Understanding the Solo 401(k)

Updated: Oct. 6, 2020, 2:36 p.m.

Self-employed workers often have a lot more freedom than their traditionally employed counterparts, but they face unique challenges, too. One of the biggest is the lack of an employer-sponsored retirement account.

When you're self-employed, the burden of saving enough rests entirely on your shoulders, but a solo 401(k) can make meeting that challenge a little easier. It's similar to a traditional 401(k), but it's designed specifically for the self-employed. Here's what you need to know about it.

What is a solo 401(k)?

A solo 401(k), sometimes known as an individual 401(k), is a type of retirement account designed for self-employed people with no full-time employees. There is an exception if your spouse works for your business. In that case, both of you may contribute to a solo 401(k).

It works similarly to a 401(k) a traditional worker might be offered through their job, but because self-employed people act as both employee and employer, they can contribute larger sums each year.

Benefits of a solo 401(k)

The biggest advantage of a solo 401(k) is the opportunity to choose the type of plan and the investment options that work best for you. Traditionally employed workers are limited to what their company offers, which might not be what's best for their money. When you're the boss, you select how you're going to invest your funds based on your risk tolerance. You also get to decide which type of 401(k) provides you the best tax advantages.

Solo 401(k)s come in two varieties: traditional and Roth. Traditional solo 401(k)s are tax-deferred. You make contributions with pre-tax dollars, and these reduce your taxable income for the year. But then you must pay taxes on your solo 401(k) distributions in retirement. It's a smart play for those who think they're earning more money right now than they'll be spending annually in retirement. Delaying taxes until your income is lower will help you hold on to more of your hard-earned money.

Roth solo 401(k)s work the other way. You pay taxes on your contributions this year, but the money grows tax-free afterward. When you withdraw the funds in retirement, you get to keep it all for yourself. This is a better choice for those who think they're earning about the same as or less than what they expect to spend annually in retirement. In this case, paying taxes now will cost you a smaller percentage of your income than waiting.

In exchange for these tax benefits, the government usually doesn't allow you to withdraw your solo 401(k) funds before 59 1/2, unless you use the money for a qualifying exception, like a first-home purchase or a large medical expense. You can withdraw Roth solo 401(k) contributions at any time, however, as long as you've had the account for at least five years. Withdrawing money without a qualifying reason before 59 1/2, on the other hand, results in a 10% early withdrawal penalty.

Contribution limits for a solo 401(k)

Self-employed workers may contribute up to $57,000 to a solo 401(k) in 2020, or $63,500 if 50 or older. This limit is a lot higher than what traditional employees can contribute to a 401(k), because self-employed workers can make employer contributions as well.

The employee contribution is $19,500 in 2020 or $26,000 if you're 50 or older. This is the same amount traditionally employed workers are allowed to contribute to their 401(k)s.

The employer contribution is up to 25% of your net self-employment income, which is defined as all your self-employment earnings minus business expenses, half your self-employment tax, and money you contributed to your solo 401(k) for your employee contribution. For example, if you earned $100,000 in net self-employment income, you could make an employer contribution of up to $25,000 to your solo 401(k).

Your maximum contribution is the lesser of the annual contribution limit -- $57,000, or $63,500 if you're 50+, in 2020 -- or your employee contribution plus 25% of your net self-employment income. So you cannot contribute more than $57,000, even if your employer contribution would allow for it, and you can't exceed your maximum employee and employer contributions for the year, even if you haven't hit the annual limit.

Explore Related Retirement Options

How to start a solo 401(k)

Follow the steps below if you're interested in opening up a solo 401(k).

  1. Get an Employer Identification Number (EIN): You need an EIN to open a solo 401(k). You can apply for one of these on the IRS's website.
  2. Choose your broker: Explore different companies and look into their investment offerings, their fees, and their customer service.
  3. Fill out the appropriate paperwork: Your broker will send you an adoption agreement and an application to fill out before you can put money into your account.
  4. Fund your account: You may put money into your solo 401(k) by sending a check or using direct deposit to fund the account.

Once you've done these four things, you may begin choosing your investments and making regular contributions to your account. You can also roll over funds from other retirement accounts in your name if you choose.

You must make your solo 401(k) employee contributions by Dec. 31st, but you have until the tax-filing deadline for the year -- usually April 15th of the following year -- to make your employer contribution.

One last thing to note is that if you have $250,000 or more in your solo 401(k) by the end of the year, you're required to submit a Form 5500-EZ to the IRS with your taxes for that year so you don't run into troubles with the federal government.

A solo 401(k) isn't right for everyone, but it's worth considering if you're self-employed. It'll enable you to save much more annually than an IRA would, and you still get the same tax benefits.