Why a Solo 401(k) Offers Big Savings Opportunities for the Self-Employed

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Editor's Note: This story originally appeared on NewRetirement.

If you are self-employed (or could be), you should know about a unique retirement savings opportunity: the solo 401(k), also known as the one-participant 401(k) plan, or the individual 401(k).

In fact, the advantages of this savings vehicle are so great that it may be worthwhile to start your own business.

Here’s a look at who is eligible, how it works, and how much you can save.

Quick Facts About the Solo 401(k)

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There are no age or income restrictions, beyond requiring that you have earned income, verified through tax records.

The key is that you must be a business owner with no employees, except for an employee who also happens to be your spouse. (And, it may be worthwhile to hire your spouse to increase your contributions. See below.)

Massive contribution limits are what make the solo 401(k) so interesting. And, you can make contributions both as the employer and an employee.

Employer solo 401(k) contribution limits: As the employer, you can contribute up to 25% of your compensation, not to exceed $58,000 for the 2021 tax year.

Employee solo 401(k) contribution limits: As the employee, you can defer 100% of your compensation up to $19,500 (or $26,000 if you are 50 or over) for the 2021 tax year.

Note: Employee contributions may be pre-tax or after-tax (Roth). There is also the option for after-tax non-Roth, but this is very rare and has limited utility. All employer contributions are pre-tax.

Combined solo 401(k) contribution limits: The combined amount of employer plus employee contributions can’t exceed $58,000 ($64,500 if age 50 or older) for the 2021 tax year.

Combined contribution limits with your employee spouse: So, if you own your own business and you employ your spouse, you can contribute up to $116,000 ($129,000 if over 50).

In other words, you can contribute a lot.

And, contributions to a solo 401(k) do not prevent you from also contributing to other retirement plans like an IRA. You can still contribute the maximum there too, as long as you have income enough to support it.

Model your contributions (and self-employed work income) in the NewRetirement Planner. Evaluate tax consequences and savings growth on your cash flow and future net worth.

Great Way to Save and a Phenomenal Way to Catch Up Later in Life

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A solo 401(k) allows you to make really big contributions to your retirement savings. And, you can even contribute to a Roth account.

Matt is ecstatic about his solo 401(k). He says, “I wish I could have created a Roth earlier, but I have always had financial constraints preventing it — i.e. earnings over a certain amount didn’t allow it, and my 401(k) plans didn’t offer it — or maybe some did and I never realized it.”

He adds, “As it was, I got into 401(k) plans fairly late since I worked mainly for small companies. But now that I ‘retired’ with a part-time job, I discovered the idea of an individual (solo) Roth 401(k). This is almost too good to be true.”

Huge Tax Benefits

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You get all the benefits you would get from a regular 401(k) or IRA (or even a regular Roth IRA for employee contributions) — just supersized due to the larger contribution limits.

Depending on the type of accounts you use, tax benefits may include:

  • Lower adjusted gross income (AGI)
  • Tax-deferred contributions and tax-free growth on earnings
  • Tax deductions for the cost of the plan

12 Big Advantages of a Solo 401(k)

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1. Pro: Running your own business is rewarding.

2. Pro and Con: You need to run your own business and make adequate money to fund your life (if necessary) and the solo 401(k) investment.

3. Pro: Massive contribution limits enable you to make up any lost time pretty quickly. This is great if you didn’t save as early or as much as you would have liked.

4. Pro: Many tax benefits — supersized.

5. Pro: You can make up lost time pretty quickly for what was missed in the early years, assuming you don’t actually need too much of the earnings from your self-employment to get by.

6. Pro: Roth options are possible. This is massively compelling to people who wanted to save in a Roth account because they think that tax rates will be higher in the future, but could not due to high earnings.

NOTE: You can only contribute to a Roth plan with your employee contributions, not as employer.

7. Pro: Relatively simple to set up.

8. Pro: Flexible investment options.

9. Pro: With a solo 401(k) you can borrow up to $50,000 or 50% of your account value — whichever is less — at a low interest rate. The loan can be used for any purpose.

10. Pro: You control the account. You do not need a “custodian” to administer the account.

11. Pro: The plans are easy to operate and don’t generally have any hidden fees.

12. Pro: Solo 401(k)s allow you to invest in real estate without having to pay the Unrelated Business Taxable Income (UBTI). UBTI taxes are high. Note that there are certain restrictions on the management of real estate held within the account.

Cons to a Solo 401(k)

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There is not much bad to say about a solo 401(k).

1. Con: Some additional paperwork with the IRS after you have $250,000 in the plan.

2. Con: Running your own business can be hard.

3. Con: You can only contribute self-employment earned income.

How to Open a Solo 401(k)

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You need an Employer Identification Number and earned income verified by the IRS, but a solo 401(k) is easy to open. They are offered by most online brokers.

  1. Acquire an Employer Identification Number. (Apply with the IRS.)
  2. Contact a broker: Vanguard, Schwab, Fidelity, Etrade, or similar.
  3. Complete a plan adoption agreement and account application. (Plans must be opened by Dec. 31 for contributions to count for this year.)
  4. Contribute funds. (Employee contributions must be done by the end of the year. However, employer profit-sharing contributions can be done up until your tax filing deadline for the tax year.)
  5. Invest your money in almost any investment offered by your broker.
  6. Once your plan has more than $250,000, you will need to complete Form 5500-SF for the IRS.

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