What is a Solo 401(k)
Even though there are a variety of tax-advantaged retirement savings options available to American workers, the selection wasn’t always great for self-employed individuals.
Contribution limitations, restrictions on business structure, and even heavy administrative burdens are just a few examples of the tradeoffs that left many without a viable option.
It wasn’t until 2001 that legislation was put in place that established a path for self-employed individuals to fund a 401(k) from the revenues in their business.
Thankfully, these plans provide a great balance of flexibility without overly burdensome administrative hurdles to clear making them a great option for retirement saving and investing.
Solo 401(k)
Self-employed 401(k)/Individual 401(k)/Solo 401(k) plans were established to provide a retirement saving option to self-employed individuals with benefits that rivaled common 401(k) plans while eliminating many of their administrative headaches and costs.
In order to contribute to a Solo 401(k) you must have self-employment income while not employing any other “full-time” employees who would be eligible to participate in the plan (except for spouses which we’ll cover later).
A full-time employee is generally defined as anyone who works 1,000 or more hours in a year. So, if you have employees in your small business, they don’t have to work 40 hours a week to be considered full-time. At least, not by this rule.
Non-resident aliens, employees under 21, and union members with other retirement benefits may also be excluded.
Contributions can be made to a Solo 401(k) both as the employee (employee deferrals) and as the employer (employer contributions), and the limits for these contributions are nearly identical to those for standard 401(k) plans.
In 2024, this means one could contribute up to $23,000 to a Solo 401(k) as an employee deferral and up to $30,500 if age 50 or older.
Employer contributions also have the same maximums that normal 401(k) plans do, but they are limited to the lesser of 25% of your net self-employment income or $69,000 ($76,500 if 50+). Net self-employment income is all of your business revenue minus business expenses, half of your self-employment taxes, and employee contributions to your Solo 401(k).
Contributions to a Solo 401(k) can be made on either a Roth or Traditional basis.
One Way to Save More and Another Way You Can’t
If you happen to have access to another 401(k) plan, perhaps because your self-employment income is from a side hustle, then you need to remember that your employee contributions are limited to $23,000 in the aggregate for all plans.
This means you cannot direct more than $23,000 from employee earnings into all of your 401(k) plans combined in a single year.
However, employer contributions to 401(k) plans are limited to each individual account which means as the employer, you can contribute up to $69,000 to each 401(k) plan you have; leaving room for you to direct tens of thousands of dollars into 401(k) plans each year.
For example, let’s assume some random guy named Curt who works for a large utility during the day starts a website and YouTube channel on the side and it proves to be quite profitable (I’m dreaming here, but please bear with me).
Curt already has access to a 401(k) through his daytime employer and contributes the maximum of $23,000 in 2024. Curt’s employer also provides a partial matching contribution to this 401(k) plan.
Curt also decides to open a Solo 401(k) through his side hustle and in 2024 he funds the account with employer contributions only. Because none of the contributions were made as employee deferrals, Curt can potentially deposit up to $69,000 into his Solo 401(k) as the employer.
In other words, by using a Solo 401(k), Curt could potentially move up to $138,000 into 401(k) plans in 2024. If he was 50 or older, he could contribute up to $153,000!
Obviously, you would need to be quite the entrepreneur to produce this much income, but it illustrates the saving potential Solo 401(k) plans provide.
But wait…there’s more!
The Impact of Your Spouse
Earlier we mentioned that contributions to Solo 401(k) plans can only be made by self-employed individuals with no employees.
There is one very convenient exception to this rule: your spouse.
If your spouse receives income from the business, then they can also receive and make contributions to the Solo 401(k) (in their own name) with a fresh set of contribution limits. This effectively doubles the contribution capacity of your Solo 401(k).
There will have to be enough income from the business to support such a high level of contributions, but it is worth noting in case your business does well.
There are a few different ways to set up your business for your spouse to receive this benefit.
- The most common is a single-member LLC or sole proprietorship where the spouse receives a W-2 for their wages.
- You could also set up a partnership where each spouse takes income from the business and reports their earnings through a K-1.
- Finally, if the business is set up as an S-corp or C-corp, both spouses will receive a W-2 for wages earned.
If your spouse stops working in the business, they can keep their 401(k) but they will no longer be able to make contributions.
How Do I Set Up a Solo 401(k)
Most online brokerages and investment banks provide Solo 401(k) options and most can be operated free of charge if you have a certain level of invested assets with the plan administrator.
You can also open a Solo 401(k) on a self-directed basis which could provide you with access to a broader range of less traditional retirement investments like real estate, crypto, private business, or precious metals.
Before setting up a Solo 401(k), you’ll need an Employer Identification Number which can be obtained on the IRS website.
As you evaluate plan custodians, be sure you understand their fee structure, the types of assets you’ll have access to from your plan, and what other flexibility they have to offer in terms of loans, rollovers, and the like.
Once the assets in all of your aggregate Solo 401(k) plans reach $250,000 you’ll have to file form 5500-EZ with your tax return. There are no taxes owed for this. It is just a reporting requirement.
Wrap Up
Solo 401(k) plans are an outstanding investment option for self-employed individuals, combining a useful mix of flexibility and a palatable administrative load.
If you have self-employment income and no employees, other than your spouse, you’ll be hard-pressed to find a more valuable retirement savings account than a Solo 401(k).
For more about 401(k) plans, check out our YouTube channel and playlist about 401(k)s.
