Since the 2008 recession, the number of people working on their own as independent contractors through freelance arrangements has risen dramatically, and many former employees have decided to create their own businesses. Without an employer to provide a 401(k) plan, you might think that the self-employed have to make do with IRAs and other retirement savings options. Yet there are options for self-employed workers to set up their own 401(k) plans, and these so-called solo 401(k) or self-employed 401(k) arrangements can give you most of the advantages of an employer 401(k) with the opportunity to save even more than most employees ever can. Let's take a look at the solo 401(k) to see whether it's a good option for you.
The basics of the solo 401(k)
The solo 401(k) is a special type of 401(k) plan that's designed to cover only one person, with the option of adding that person's spouse to the plan as well. As a result, it's designed for businesses without ordinary outside employees. The rules for regular 401(k)s still apply to solo 401(k)s, although some of them -- such as the nondiscrimination testing provisions -- are automatically met when there's only one participant.
The interesting thing about the solo 401(k) is that you get to act both as employer and employee. In your role as employee, your solo 401(k) will let you contribute up to the normal employee maximum of $18,000 per year, with $6,000 in catch-up contributions if you're 50 or older. As long as you have that much in compensation, you can easily keep up with what an employee can save in an employer 401(k) plan.
As employer, though, you can make even bigger contributions to your 401(k). Employer contributions are allowed up to 20% of your net earnings from self-employment, after allowing for the deductible portion of your self-employment taxes for the year. That makes calculating the maximum contribution somewhat complicated, but the general idea is that if that amount is more than your normal employee contribution maximum, then you're allowed to contribute the additional amount as an employer contribution. There are limits to how much you can contribute in total, but they're much higher than the standard 401(k) contribution limits. In 2015, you can contribute up to $53,000 in total employee and employer contributions -- but only if you make enough in self-employment income to reach that maximum amount.
Advantages and burdens of the solo 401(k)
Getting to set aside huge amounts of money toward your retirement is the biggest advantage of the solo 401(k) for successful self-employed businesspeople, but it's not the only one. Financial providers generally make setting up a solo 401(k) easy, and many of them open up a full array of investment options for you to choose from rather than limiting you to a set menu of mutual funds. It's not uncommon to have solo 401(k)s offer access to a brokerage option that opens up the entire universe of stocks, bonds, exchange-traded funds, and other permissible investments within a retirement account.
One thing to bear in mind, though, is that a solo 401(k) makes you an employer-plan administrator, with all the responsibilities that come with that role. In particular, you have to make sure that all the documentation for your solo 401(k) remains current, or else you could inadvertently endanger your plan's tax-exempt status. In addition, if your retirement assets in the solo 401(k) ever exceed $250,000, then you have to complete an information return on Form 5500-SF or 5500-EZ with the IRS to keep it apprised of the status of your solo 401(k) plan.
Even with those responsibilities, the ability to boost your retirement savings is generally well worth the hassle of setting up and maintaining a solo 401(k). For those who've successfully set up their own self-employed business, a solo 401(k) is a great way to provide for your retirement needs in the future.