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What Is a Solo 401(k)?
If you’re a freelancer or an independent contractor, you might assume that you don’t have access to a 401(k). But that just isn’t true. You don’t have to go without a tax-advantaged retirement savings plan: you can sign up for what’s called a solo 401(k), or a self-employed 401(k). Read on to learn what’s involved, and how to set one up.
Key Takeaways
- If you’re self-employed and don’t employ others, you’re eligible to open a solo 401(k).
- A couple running a business together also qualifies.
- You can contribute to your solo 401(k) as both employer and employee.
- For 2024, you can contribute a combined total of $69,000 (up from $66,000 in 2023). If you’re age 50 or older, you can add another $7,500.
- You can choose between a traditional plan or a Roth plan. Each has its own tax advantages.
Eligibility Requirements
To qualify for a solo 401(k), you must produce your income from your own business. And the business must be run by you alone, or you and your spouse.
Sole proprietors, small business owners without employees (except for a spouse), independent contractors, and freelancers typically fit this description. The business must also produce income. This is verified through your tax records.
If you meet these criteria, you can open a solo 401(k) plan.
If you’re an independent contractor or freelancer with no employees, your business can take any form, whether it’s a sole proprietorship, an LLC, a corporation, or a partnership.
How to Set up a Solo 401(k)
1. Find Your Broker
You can open a solo 401(k) at most online brokers and traditional brokers or directly through a financial services company. You’ll want to do some research ahead of time to identify the best solo 401(k) company for you.
2. Get an EIN
You’ll need an employer identification number (EIN) to get started with the enrollment process. If you don’t have one already, you can apply online with the Internal Revenue Service (IRS).
The rest of the documentation will be provided by the broker or financial services company you choose for the account.
3. Choose: Traditional or Roth?
To open a solo 401(k) plan, you have to adopt a plan in writing, making a written declaration of the type of plan you intend to fund. The choices are the same as those given to an employee opening a 401(k) plan: you can choose a traditional 401(k) or a Roth 401(k). Each has distinct tax benefits.
If you have a traditional 401(k) plan, you’re investing with pretax dollars. That is, you’re effectively claiming an immediate tax break for your contributions as you make them throughout your working years.
When you reach retirement age, you’ll owe income taxes on the funds as you withdraw them. You’ll pay taxes on your initial deposits as well as on the money your investments have earned over the years.
Keep in mind that most people are in a lower tax bracket after retiring than they were during their working years. If you anticipate being in a higher tax bracket, you might wind up paying a hefty extra amount in taxes down the road.
Roth plans, on the other hand, are funded with after-tax dollars. Since you’ve already given the IRS its cut, your withdrawals are tax-free after you retire, as long as you’ve had the account for over five years. That’s totally tax-free, including the money you paid in and the investment returns the account earned.
This could add up to a nice fat bank account for your retirement years. However, keep in mind that it’s a bigger hit to your spending power during your working years.
A solo 401(k) must be set up by Dec. 31 in the tax year for which you are making contributions.
4. Create a Trust
Once you have established the type of plan you want, you will need to create a trust that will hold the funds until you need them or you reach retirement age. You can select an investment firm, online brokerage, or insurance company to administer the plan for you.
5. Create a Record-Keeping System
You also need to establish a record-keeping system, so that your investments are accounted for properly.
Benefits of a Solo 401(k)
Solo 401(k)s provide some advantages over other types of retirement accounts available to you.
Roth Option
One big advantage is the availability of the Roth option as well as the traditional version. With other self-employed retirement accounts, such as the Simplified Employee Pension (SEP) IRA, the Keogh plan, and the Savings Incentive Match Plan for Employees (SIMPLE) IRA, only the traditional option is offered; there are no Roth options.
The regular IRA that’s available to anyone with earned income is available in Roth or traditional versions, but the annual contribution limits are far lower.
High Contribution Limits
Another advantage of the solo 401(k) is that it can accept contributions from both an employee and an employer. That is, if you have a solo 401(k), you wear both hats and can make contributions in both roles.
The contribution limits are adjusted for inflation every year by the IRS.
With a solo 401(k), you can contribute up to $69,000 for 2024 (up from $66,000 in 2023) or 25% of your adjusted gross income, whichever is lower.
People age 50 and older can add an extra $7,500 a year as a “catch-up contribution”. In other words, in 2023 you could contribute a total of $66,000 ($22,500 as an employee + $43,500 as an employer) along with a $7,500 catch-up contribution if applicable for a maximum of $73,500 for the year. In 2024, it’s $76,500.
Added Flexibility
The SEP IRA is an alternative retirement plan that is often recommended for small business owners. But the solo 401(k) has an advantage over the SEP: you can take loans from the plan before retiring. In general, it’s not advisable to borrow from your retirement fund, but it’s an option if you must.
The solo 401(k) has another advantage over the SEP IRA: you get to choose between a Roth and a traditional account. The SEP IRA can only be a traditional account.
Less Paperwork
The solo 401(k) is designed for use by sole proprietors, freelancers, and independent contractors. As such, it eliminates much of the paperwork and bureaucracy that go along with setting up and managing a 401(k) in a corporation.
More Investment Options
You have a world of options to choose from in selecting how to invest your money for retirement. Most companies offer their employees a limited selection of funds from a single financial services firm. You have no limits except for a few that the IRS imposes. You can’t play the derivatives market or invest in stamps or comics, for example.
Otherwise, you can invest in stocks, bonds, mutual funds, exchange-traded funds, and many other types of investments.
Alternatives to a Solo 401(k)
There are basically two options in addition to the solo 401(k) for freelancers and independent contractors who want to save for retirement and get the tax advantages that accompany these IRS-approved options:
- The SEP IRA is designed to be an easy, flexible option for small businesses with employees. It works much like a traditional IRA but has higher contribution limits. The limits are the same as for the Solo 401(k): $69,000 for 2024 (up from $66,000 in 2023); however, your contribution cannot exceed 25% of your gross adjusted income. No catch-up contribution is allowed for those age 50 or older. No Roth option is available. A SEP IRA can be opened through any brokerage or bank.
- The Keogh Plan is open to sole proprietors, partnerships, and limited liability companies and is often used as a profit-sharing vehicle for professional practices such as doctors’ and lawyers’ groups. It has the same contribution limits as the SEP IRA and the Simple 401(k) but poses a greater administrative burden. There is no Roth option.
- The SIMPLE IRA is designed for businesses with 100 or fewer employees. It is open to sole proprietors but has a lower contribution limit than the Solo 401(k) or the SEP IRA. The maximum contribution is up to 3% of salary plus $16,000 in 2024 (up from $15,500 in 2023). There is no Roth option.
- Finally, the regular IRA is available to all earners. The limit is $7,000 for 2024 (up from $15,500 in 2023). If you are 50 or older, you are allowed a catch-up contribution of $1,000.
Who Qualifies for a Solo 401(k)?
You’re eligible to open a Solo 401(k) if you are self-employed and have no employees. A couple running a business jointly also qualifies.
What Are the Benefits of a Solo 401(k)?
Unlike other options, a solo 401(k) account holder can choose between a traditional option and a Roth option. The traditional option allows you to deduct the amount you pay from your income for that year, giving you an immediate tax break. With the Roth option, the income taxes on that money are paid immediately and you owe no taxes when you withdraw the funds.
The solo 401(k) has far higher annual contribution limits than a regular IRA, although that is also true for the SEP IRA and the Keogh plan.
The Solo 401(k) allows you to take loans from your account before you retire. This is not an option with many other retirement plans.
Finally, the solo 401(k) is relatively straightforward in terms of paperwork, as it is designed for one-person shops, not corporations.
How Much Can I Contribute to a Solo 401(k)?
The most a person under age 50 can contribute to a solo 401(k) is $69,000 for 2024 (up from $66,000 in 2023). People age 50 and older can add an extra $7,500 as a “catch-up contribution.” Those numbers all include the person’s combined contributions as employer and employee.
How Much Does It Cost to Open a Solo 401(k)?
There is no cost to open a 401(k) account, but watch out for fees later on. While you’re researching your options, check for account maintenance fees, transaction fees, commissions, mutual fund expense ratios, and sales loads.
A fractionally higher fee can mean a big hit to a retirement portfolio. If you make the right choices you can minimize the fees you pay.
The Bottom Line
If you are self-employed, you have several options for saving for retirement while saving on your taxes. You don’t have to settle for a regular IRA, which is available to anyone with earned income but sets the maximum annual contribution at a comparatively low level.
Instead, you can opt for one of several types of retirement plans that have much more generous limits with similarly generous tax benefits. The solo 401(k), the SEP IRA, the Keogh plan, and the SIMPLE IRA all are possibilities.
However, the solo 401(k) is the only option that offers you a choice of a Roth account or a traditional account, while still allowing for the maximum yearly contribution available among tax-advantaged retirement plans.