Solo 401(k)s: Retirement Savings for Individuals Who are Self-Employed

Are you self-employed? Are you thinking of becoming a sole proprietor? Do you love the idea of working for yourself but have concerns about saving for retirement? A solo 401(k) may be what you need to secure your future retirement!

A solo 401(k) is a special retirement account for individuals who are self-employed and don’t have employees (aside from a spouse.) Solo 401(k)s provide the opportunity to save more money for retirement than an IRA allows.

Contributions to a solo 401(k)

Two types of contributions are allowed for solo 401(k)s:

• Employee Contribution – This contribution limit is the same as the limit for a traditional 401(k). In 2021, you may contribute $19,500 if you are under age 50, or up to $26,000 if you are over age 50.

• Employer Contribution – If you’d like to contribute more than the maximum employee contribution, the employer contribution allows up to 25% or $290,000 of your net self-employment income for the year.  

In 2021, the total amount that can be contributed to a solo 401(k) as an employee and employer is $58,000 if you are under age 50 or $64,500 if you are over age 50.

Withdrawing from a solo 401(k)

Taking a loan from a solo 401(k) is the same as taking a loan from a 401(k), and should be used as a last option. While you can have the cash, your money will not continue to grow until it is reinvested. Additionally, if the loan is not paid back within 5 years, it will be considered and taxed as a distribution.

Spousal contributions to solo 401(k)s

The spouse of the business owner is the one exception and can contribute income earned from the business to the solo 401(k) if the spouse is a co-owner or full or part-time employee of the business. The business owner and spouse can each contribute the maximum amount if both have earned enough during the year to cover contributions.

Opening a solo 401(k)

If a solo 401(k) would benefit you and your retirement savings, we recommend the following steps for opening an account:

1.    Register for an employee identification number (EIN) from the IRS. The business needs to be based in the United States, and you’ll need a taxpayer ID or social security number in order to apply.

2.    Find a brokerage where you’ll open your solo 401(k). Factors to consider when making this decision are fees, investment options, and customer service.

3.    Determine if you are opening your solo 401(k) as a tax-deferred account, a Roth account, or if you’ll open one of each. Information about the tax implications of both account types can be found below. The contribution limits apply to the total, and not to each account separately.

4.    Be aware of the deadlines. If you want to contribute for the 2020 tax year, you will need to open your solo 401(k) by December 31, 2020. Employee contributions must be made by the end of the calendar year, and employer contributions must be made by the tax deadline (April 15.)

Taxes on solo 401(k)s

As mentioned above, you can open a tax-deferred account, a Roth account, or one of each. Here is some information to help determine which is best for you:

• A tax-deferred account reduces taxable income for the year, which helps save money now, but you will owe taxes on distributions later. If you believe that you are making more money now than you will spend in retirement, a tax-deferred account makes sense. You can put off taxes until retirement when you may be in a lower tax bracket, which will allow you to keep more of your savings. Another consideration is if you withdraw money before age 59 ½, you will owe taxes on your contributions as well as a 10% early-withdrawal penalty.

• A Roth account doesn’t reduce your tax bill, however, your savings grows tax-free once you pay taxes on your contributions. If you think you are making the same or less than you will spend in retirement, a Roth account is the better option because you’ll pay less on taxes upfront than on contributions and earnings during retirement. Withdrawals from the Roth account can be taken at any time, but there could be taxes or penalties if taken before age 59 ½.

• If you choose to open multiple accounts (a tax-deferred account and a Roth account), it is suggested that you contribute more to the account that will give you the most advantageous tax breaks. Also, it will be important to keep track of your contributions to both accounts so that you do not exceed the annual limit.

Please contact me if you’d like to discuss solo 401(k)s or their taxation!