A solo 401(k), also known as an individual 401(k) or a 401(k) with only one participant, is a retirement account available to business owners with no employees. The big draw of a solo 401(k) is the high contribution limit. For 2020, business owners can contribute up to $57,000 to their solo 401(k), or $63,500 if they're over 50. For 2021, you can contribute up to $58,000 or $64,500 if you're 50 or older.
What is a solo 401(k)?
A solo 401(k) is a type of retirement savings account for self-employed individuals, or for employers with no employees besides themselves and their spouses.
To be eligible to open a solo 401(k), you need to claim some self-employment income on your tax return. It's important to keep in mind that self-employment doesn't need to be your only source of income. For example, if you work a full-time job for an employer and do some consulting work on the side, you can use a solo 401(k) to set aside some of that extra income.
The only real requirement, other than making self-employment income, is not having any full-time employees other than yourself and your spouse. If you operate a small business with part-time workers (less than 1,000 hours per year each), you can still open a solo 401(k) account.
Solo 401(k) contribution limits
One of the biggest benefits of a solo 401(k) is that its contribution limits are usually the highest of all retirement account types. Just as with a regular 401(k), contributions can be made from the employer and the employee. However, in a solo 401(k), you play both roles, so you can make both contributions.
For 2020, you're allowed to elect to defer $19,500 of your self-employment income as an employee contribution, and this limit is increased to $26,000 if you're over 50 to allow you to "catch up" on your savings. Those limits remain the same in 2021: $19,500 with a $6,500 catch-up contribution. You can contribute your elective deferral to a traditional pre-tax account or a designated after-tax Roth account.
In addition to this, you can contribute 25% of your self-employment income or compensation as an employer contribution -- up to an overall maximum of $57,000 ($63,500 if you're over age 50) or your total compensation. That limit increases by $1,000 in 2021, so you can contribute up to $58,000 (or $64,500 for those over 50). It's also important to note that your employer contribution must be made on a pre-tax basis, regardless of whether you choose to make your elective deferrals on a pre-tax (traditional) or after-tax (Roth) basis.
That means you can max out the contribution limit for 2020 with $150,000 in salary. You'd need to pay yourself $154,000 in wages to max out a solo 401(k) in 2021.
Calculating compensation for unsalaried entrepreneurs (sole proprietors) is a bit trickier. You'll have to reduce your self-employment income by the employer's half of self-employment tax as well as adjusting for the employers contribution. That means you'll need to earn about $198,700 to max out the contribution limit in 2020 and $204,100 to max it out in 2021.
You can also contribute up to $57,000 to a SEP-IRA, or $58,000 in 2021. But a SEP-IRA is similar to the employer portion of a solo 401(k); you're limited to 25% of your compensation. So you need total compensation of $228,000 to fully fund a SEP-IRA to the limit in 2020 and $232,000 in 2021.
Other retirement savings vehicles have much lower contribution limits. A SIMPLE IRA, for example, has a limit of just $13,500 for employee deferrals in 2020, and the employer portion is maxed out at just 3% of compensation. Those limits remain in place for 2021. Regular IRAs, which you can use in conjunction with a solo 401(k), are limited to just $6,000 in contributions for 2020 and 2021. So a solo 401(k) is ideal for entrepreneurs looking to save the highest percentage of their income in a retirement account.
You can make your solo 401(k) contributions up until the day taxes are due for the year. For example, if you want to max out your contributions for 2020, you have until April 15, 2021 to do it.
The results can be pretty incredible
Of course, many self-employed people don't have the ability (or need) to contribute the maximum amount allowed to a solo 401(k). However, even modest contributions add up over time.
For example, let's say that you're self-employed and that you'll have $80,000 in net self-employment income for 2021. You decide to set aside a total of 10% of your net self-employment income in a solo 401(k). Not only could this reduce your taxable income by $8,000 for the year, but if you repeat the process every year, you could end up with a retirement nest egg of more than $928,000 after 30 years -- and that assumes just 2% annual income increases and a historically conservative 7% annual rate of return.
Imagine if you decided to invest even more. With a solo 401(k), you can dramatically reduce your taxable income while building up a million-dollar nest egg.