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What is a Solo 401(k)?

What is a Solo 401(k)?
Catherine Hiles
Updated December 21, 2021
6 Min Read

A 401(k) is a type of investment account that allows you to save money for retirement. Most people will get their 401(k) through their employer, who may offer a matching contribution up to a certain percentage of your income. But what if you don’t have an employer and are a self-employed business owner instead?

Luckily, there is a similar option for business owners who do not have any employees on their staff. It’s called a solo 401(k). It’s similar to an employer-offered 401(k) in a lot of ways, but also has some key differences.

Want to learn more? Read on to find out all about solo 401(k) plans and whether they might be right for your investment portfolio.

Who qualifies for a solo 401(k)?

Not just anyone can open a solo 401(k). They are designed especially for business owners who do not have any employees. So if you run a small local business out of your home or freelance for a living, you can opt for a solo 401(k) to take advantage of the same tax breaks offered by an employer-provided 401(k). 

In order to open a solo 401(k), you need to have an employer identification number. If you don’t have one, you can get one easily (and for free) from the IRS by filling out an application

or if you co-own the business with your spouse and you both work for the business. You must be a registered business, though, because you need an employee identification number in order to open a solo 401(k).  

So, if you are a freelancer by trade, you need to register as a business in order to get an employee identification number. You can do so online at IRS.gov, and you’ll get your EIN as soon as the IRS has validated your application.

If you work full time for a company that offers a 401(k) plan and also own your own business on the side, you can still apply for a solo 401(k). But bear in mind that the IRS contribution limits are per person, so you cannot contribute more than that amount in total across your employer-provided and solo 401(k) plans.

Solo 401(k) contribution limits

Like a regular 401(k), a solo 401(k) has contribution limits. 

With an employer-provided 401(k), you would be contributing an amount as the employee, and your employer may match your contribution up to a certain percentage of your total income. A solo 401(k) is similar in that it considers you to be two different people: an employee and an employer.

As an employee, you can contribute up to $19,500 or 100% (whichever is higher) from the wages you earn from your business. That limit is set by the IRS for 2020 and 2021. Remember if you also have a 401(k) through an employer, that limit applies to your total contributions and is not a per-account limit.

As an employer, you can contribute up to 25% of your net self-employment income (i.e. your business earnings). Like with the employee contribution, the limits for the employer portion change each year and are set by the Internal Revenue Service. The most recent limits are as follows:

  • 2020: $57,000
  • 2021: $58,000

The IRS also allows you to contribute an additional $6,500 per year if you are 50 or over as a “catch-up” option.

Solo 401(k) withdrawals

Similar to an employer-provided 401(k), a solo 401(k) carries a steep 10% penalty if you withdraw any money before age 59 ½, so it’s best to wait until you reach retirement age before dipping into those funds.

Solo 401(k) plans also fall into the same two categories as other 401(k)s: traditional and Roth. Each type handles the withdrawal penalty differently. A traditional solo 401(k) will charge the 10% penalty plus income tax on all withdrawals before 59 ½. 

But a solo Roth 401(k) will only charge you the penalty for any earnings in the account (not on your contributions). That is because traditional and Roth 401(k)s treat taxes differently. 

Traditional 401(k) contributions are made pre-tax, meaning you don’t pay taxes on that money until you withdraw it. This decreases your amount of taxable income, which may mean you pay less tax overall throughout the year.

Roth 401(k) contributions are pre-taxed, so when you withdraw the money at retirement you’ll get the full amount without having to pay taxes.

Exceptions to the 10% penalty

Just like with employer-sponsored 401(k) plans, there are some emergency exceptions to the 10% early withdrawal penalty fee. If you’re withdrawing the cash for one of the following purposes, you may be able to avoid paying that penalty.

  • Permanent disability
  • Medical expenses that exceed 10% of your adjusted gross income
  • Military service
  • Withdrawal due to a divorce agreement that splits the 401(k) between ex-spouses

However, if you try to withdraw the money for any other reason, or if you cannot prove one of the above reasons for your withdrawal, you will be charged the 10% penalty plus any applicable taxes.

Required Minimum Distributions

All 401(k) plans, employer-provided and solo, require you to start taking Required Minimum Distributions, or RMDs, one you turn 72. The IRS calculates your RMDs based on your 401(k) balance and your life expectancy.

If you don’t want to take these RMDs at age 72 and you have a solo Roth 401(k), you can roll the funds over into a Roth IRA to avoid the payments. Roth IRA accounts do not have RMDs. But if you have a traditional solo 401(k), you won’t have any choice but to take the RMDs required by the IRS.

How to open a solo 401(k)

When you have a 401(k) provided by your employer you don’t need to worry about finding a provider. But with a solo 401(k) you need to decide which broker to go with. Here’s how.

Shop around

It’s a good idea to shop around and compare a few plans to find the one that’s right for you. Look at each broker and see what types of investment they provide. You can determine your provider based on what you want your money to be invested in.

Bear in mind that solo 401(k) accounts are more commonly offered as traditional 401(k)s, so you may have fewer choices if you want to go with a Roth 401(k). Make sure you ask each provider what types of solo 401(k) they offer.

Fill out an application

Just like with any financial account you want to open, you’ll need to fill out an application for a solo 401(k). You will need the usual information, such as your name and address, as well as an Employer Identification Number, or EIN. If you don’t have one for your business, you can get one for free from the IRS.

Set up contributions

You’ll want to determine how you will contribute to your solo 401(k). If you have an existing retirement plan, you can roll that over into your new 401(k). You should also set up recurring contributions from your checking or savings account to ensure you are saving the most possible money for retirement.

Frequently asked questions

Want to learn more about solo 401(k) plans? Read on to find out the answers to some of the most frequently asked questions about this type of investment account.

Is a solo 401(k) worth it?

If you are a self-employed business owner, a solo 401(k) is a good option for your retirement savings. This type of savings plan is very flexible so you can save as much (within the limits) or as little as you want to go toward your retirement. 

You don’t have to save the same amount each year; you can decide to save little to no money in a year if your business is in trouble and you need that income to help it stay afloat. On the flip side, if your business is doing very well, you can sock away a decent amount of money in a solo 401(k) to ensure you have enough to live on once you stop working.

A traditional solo 401(k) can lower your taxable income each year because you’re contributing funds pre-tax, which can be an added benefit depending on your income.

What’s the difference between a traditional and a solo 401(k)?

Most 401(k) plans are provided by your employer, who may or may not offer matching contributions as part of your benefit package. This is a great option for retirement savings if you work for a large company that has a good match rate.

But if you are self-employed, you can’t open a 401(k) in this way. In that case, you can look into opening a solo 401(k), which is available to business owners and their spouses who do not have any employees.

Can you cover your spouse under a solo 401(k)?

Although you cannot open a solo 401(k) if you have any employees, there is an exception if your spouse works for your business and earns income from you.

In that case, your contribution limit would double because you each would be able to contribute up to $19,500 per year as employees, and you could match both contributions up to 25% with your business income.

Summary

If you own your own business and do not employ any workers, you can save for retirement using a solo 401(k) plan. It’s a good option to ensure you have enough income to live off once you decide to stop working. But if you do have employees (other than your spouse) working for your business, you’ll have to look into other investment and savings options.

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