For self-employed individuals, there is no shortage of options when selecting a retirement account to pair with the business. We’ve discussed characteristics and pros and cons of Traditional and Roth IRAs, the SEP IRA, and the SIMPLE IRA. In this article, we’re discussing the characteristics of the Individual 401(k), also known as the Solo 401(k), and what it can offer to self-employed business owners.
A 401(k) is generally thought of as a plan provided by large companies with multiple employees, but the same plan is available for self-employed business owners who have no employees who are not owners (with an exception, we’ll get to that shortly). It’s referred to by many names: Solo K, Individual K, Solo 401k, Single K. So many names can be confusing, but all these variations represent the same plan. In this article, we’ll refer to the Individual 401(k) as the Solo 401(k). Now, let’s look at its characteristics and what it offers to those who are self-employed.
Contributions to the Solo 401(k)
The Solo 401(k) is a tax-advantaged retirement plan for self-employed business owners with no employees. An exception to the no-employee rule is that a spouse who works at least part-time can also contribute to his or her own account.
The business owner is considered to have two roles in the retirement plan — employer and employee. Under the role of employee, the participant can make maximum contributions of the lesser of (a) $22,500 (plus a $7,500 catch-up contribution for those who are 50 and older) for 2023 or (b) 100% of net adjusted self-employed income. For 2024, that dollar amount limit is $23,000 plus a $7,500 catch-up contribution for those 50 and older.
In the role of employer, the participant can make profit-sharing contributions of up to 25% of your net adjusted income. The employer contribution portion of the Solo 401(k) is nearly identical to the SEP IRA.
Between employer and employee contributions, either in a traditional or Roth portion of the plan, participants may be able to contribute up to the maximum of $66,000 (2023) or $69,000 (2024) plus catch-up contribution of $7,500 at age 50 and older. So participants of the Solo 401(k) can save quickly and aggressively.
If you have another job that offers an employer-sponsored 401(k), you are allowed to contribute to both plans as employee, but contributions are cumulative between both plans. Employer contributions, on the other hand, are based on plans, so unrelated employers can contribute the maximum amount to each plan. We advise you talk to your tax professional to confirm your eligibility.
Pre-tax contributions to the Solo 401(k) allow you to reduce your taxable income, possibly lowering your tax bill. In addition, your investment grows tax deferred. A self-employed person over 50 years old who contributes the maximum $66,000 to their Solo 401(k) plus the catch-up contribution of $7,500 can defer $73,500 of income in 2023. If they’re paying 30% income tax combined between federal and state, that’s $22,050 of tax savings! Alternatively, contributions can be Roth as opposed to pre-tax, which we’ll discuss later.
Withdrawals From the Solo 401(k)
Account owners are eligible for withdrawals at age 59½. Early withdrawals can be made, but they incur a 10% penalty plus income tax on the amount drawn. There are exceptions, which include some types of military service, medical expenses exceeding 10% of adjusted gross income, permanent disability, and as part of a Qualified Domestic Relations Order (retirement account settlement as part of a divorce decree).
Withdrawals after age 59½ are taxed as ordinary income based on your tax bracket for the year of the withdrawal. Like an IRA, required minimum distributions (RMDs) must be taken the year of your 73rd birthday for all pre-tax dollars, but Roth dollars are not subject to RMDs. When you eventually do withdraw from a Roth Solo 401(k), withdrawals are tax-free.
Solo 401(k) vs. SEP IRA
The Solo 401(k) and SEP IRA are often compared. Bear in mind that the Solo 401(k) is basically a SEP IRA (the part of the Solo 401(k) that the employer contributes to) with the additional option for employee contributions (including Roth). It’s really a matter of whether one wants just employer contributions or both employer and employee contributions.
So what are the advantages and disadvantages? Let’s take a look.
Benefits Over SEP IRA
The biggest difference and advantage to the Solo 401(k) is the contribution limits. You can contribute much more to a Solo 401(k). Remember, the Solo 401(k) can be thought of as a SEP IRA which receives contributions from the employer, but the employee can also contribute additional dollars.
- Catch-Up Contribution: The catch-up contribution of $7,500 for 2023 and 2024 for those 50 and older is another advantage to the Solo 401(k). Since the SEP IRA does not have the employee contribution portion, it doesn’t have catch-up contributions. Therefore, the Solo 401(k) beats it out as having the potential for the highest contribution limit.
- Roth Option: A valuable option to the Solo 401(k) is the Roth account. Roth dollars are valuable if your tax bracket might be higher in later years compared the current tax year. Roth contributions come from income that is taxed in the current year, and withdrawals after 59½ are tax-free. Not only is there the option to contribute to a Roth portion with a Solo 401(k), but there are also no income phaseout limits as with contributions to a regular Roth IRA. Thus, the Solo 401(k) allows high earners the ability to build Roth dollars, which can be advantageous for withdrawals at retirement, as well as passing on as a tax-free inheritance account. SEP IRAs have a Roth option beginning in 2023, but for the person trying to maximize the amount of Roth dollars in a Roth retirement account, the Solo 401(k) wins out.
- After-Tax, Non-Roth Option: This is where things can start to get complicated. There is third contribution type called after-tax contributions, which are not Roth contributions. After-tax, non-Roth contributions are contributed by the employee with after-tax dollars. The growth is tax-deferred rather than tax-free. After-tax, non-Roth contributions can be made beyond the typical $22,500 (2023) or $23,000 (2024) employee limit, which allows the self-employed person to contribute even more dollars in their Solo 401(k). Total contributions still need to remain below $66,000 (2023) or $69,000 (2024) ignoring the catch-up, but when considering that employee contributions are limited to 100% of W2 income and the employer contributions are also limited to 25% of net self employment income, after-tax dollars can effectively increase the contribution limit. Now comes the kicker: after-tax contributions enable the self-employed person to make a mega-backdoor Roth contribution, which is a roundabout way to get a bunch of Roth dollars into an account for retirement.
- Spouse Contributions: A spouse who is at least a part-time employee and receives compensation can make his or her own contributions up to the maximum amount of $22,500 (2023) or $23,000 (2024). Spouses may also receive employer contributions like they would with a SEP IRA.
Drawbacks From SEP IRA
- Complexity: Opening a Solo 401(k) is a little more administratively complex than the SEP IRA. Required documents are generally provided by the plan provider.
- No-Employee Rule: The Solo 401(k) does not offer the flexibility to add non-owner employees to the plan. If you’re a business owner and you add non-owner employees, your Solo 401(k) will remain a 401(k) but it will become subject to various testing, reporting, and discrimination rules that do not apply when the only employees are owners and their spouses.
How to Open a Solo 401(k)
There are many retirement plan providers you can find with an internet search with varying fees and investments options. You’ll want to pay attention to what types of investments are available and look for investments that are diversified across asset classes — large, mid, and small stocks; varying bonds; and domestic and international exposure. Of course, what you choose to invest in depends on your investment objectives. Some asset classes will be more appropriate for you than others.
Once you choose a provider, you will sign an adoption agreement with that plan provider. You may need an EIN depending on your business entity type. If your business is a sole proprietorship, you can use your social security number.
There are valuable advantages to the Solo 401(k), but it needs to be considered in the context of your business plan. Consulting with a financial planner or tax professional is a good first step to get comprehensive information that may be unknown to you. You can reach out to us to see how we might be able to help.
We’ve discussed several self-employed retirement plans, but we’re not done yet! We still have one more retirement plan to discuss, the Cash Balance Plan. Keep your eyes open for our last article in a couple weeks. And in the meantime, reach out to us if you have any questions.
