When you think about retirement plans that you start on your own, you might initially think of individual retirement accounts (IRAs), but they’re not the only option. If you're self-employed or you own a business with no employees, you can start a solo 401(k) instead. These retirement accounts give you the benefits of both employer-sponsored 401(k) plans and self-employed IRAs.
What is a solo 401(k)?
A solo 401(k) is a traditional or Roth 401(k) plan that covers only one person. If you're a small business owner with no employees (even if you have partners in your business), then you qualify for a solo 401(k). As such, solo 401(k)s make great self-employed retirement plans if you're a freelancer or solopreneur. Your solo 401(k) can also cover your spouse in certain circumstances.
In general, a solo 401(k) provides the same opportunities as an employer-sponsored 401(k) plan. It allows freelancers and solopreneurs the ability to save money for retirement. Each month, you set aside a certain amount of money that goes into an investment account that continues growing (hopefully) until you are ready to retire. Similar to the traditional employer-sponsored plans, there are tax advantages to choosing a traditional or Roth plan. The traditional plan allows you to set aside pretax money, with taxes being deducted when you start taking money out of the account, while the Roth plan invests post-tax dollars, with no taxes being taken out when the money is withdrawn.
While the premise of both types of plans is the same, there are some key differences between solo 401(k)s and employer-sponsored 401(k) plans. We'll explain how solo and employer-sponsored plans do and don’t overlap below.
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How does a solo 401(k) work?
Solo 401(k)s have the following rules:
Any business owner who does not have employees qualifies for a solo 401(k). This holds true no matter your age or income, as long as you're a freelancer, a self-employed person, or a business owner whose company has no employees. You even qualify for a solo 401(k) if the no-employee business you own is classified as a corporation.
Employer-sponsored 401(k)s allow for employers to match their employees' contributions, though such matching is not required as it is for SEP IRAs and SIMPLE IRAs. Since you're both the employee and employer if you have a solo 401(k), the concept of employer matching is moot. However, you can make separate solo 401(k) contributions, known as employer nonelective contributions in your company's name.
Sole retirement account
As a small business owner with no employees, you cannot have both a solo 401(k) and a SEP IRA. However, you can have more than one retirement account if your small business is not your main source of income. If you also work full-time at a company that offers a traditional 401(k), you can participate in your full-time job's 401(k) plan. In this scenario, you can have both a solo 401(k) and an employer-sponsored traditional 401(k).
To fund your solo 401(k) beyond the contributions you make from your income, you can roll over funds from any pre-tax (non-Roth) IRA. Likewise, if you start another retirement plan in addition to your solo 401(k) plan, you can roll over your solo 401(k) funds to that plan as long as it's a pre-tax account.
If your spouse is involved in and earns money from your business, they, too, can contribute to your solo 401(k). Your spouse will face the same individual contribution limits as you do.
Discrimination testing is not required as with several other types of 401(k) plans. That's because solo 401(k)s inherently treat all participants equally, since there are at most two participants: just you, or you and your spouse.
If your solo 401(k) is a traditional 401(k), then you will be required to take distributions from the account in retirement. These distributions become mandatory when you reach 72 years of age, and they are taxed as income.
If your solo 401(k) is a Roth 401(k), then unlike employer-sponsored plans, the same required minimum distribution rules apply. That's because, with Roth 401(k)s, if you're still working at age 70 1/2 and don't own more than 5% of your company, you can postpone your distributions. However, since you have a solo 401(k), precisely because you own most or all of your company, you will still have to take the required minimum distributions from your Roth 401(k).
Solo 401(k) contribution limits
Since you're both the employer and employee in a solo 401(k) plan, your plan's contribution limits will work somewhat differently than with employer-sponsored plans. That said, you'll still have the same contribution limits as you would if you were an employee on an employer-sponsored 401(k) plan.
For 2021, you can contribute up to $19,500 of your personal income to a solo 401(k) plan, with an additional $6,500 allowed if you're 50 or older. Note that these limits apply across all your 401(k) plans.
Solo 401(k)s also allow for employer nonelective contributions that your company, not you, deposits into your account. Employer nonelective contributions are limited to 25% of your income, and in 2021, you can only make nonelective contributions based on the first $290,000 of your income. As such, if your income is $300,000, then your employer nonelective contribution limit is 25% of $290,000, not 25% of $300,000.
Solo 401(k)s and taxes
How your solo 401(k) affects your taxes depends on whether you open a traditional or Roth solo plan. If your solo 401(k) is traditional, then you’ll add your pretax income to it, meaning that your contributions are tax-deductible. And because you've deferred taxes on your contributions, your retirement-age withdrawals are taxed as income.
On the other hand, Roth 401(k) income contributions are made after taxes, thus rendering your contributions non-deductible. However, your required minimum distributions in retirement will be tax-free. Additionally, Roth 401(k) plans generally allow for more flexibility and lower fees for non-retirement withdrawal.
Given these tax rules, you may prefer Roth 401(k) plans if you expect to be in a higher tax bracket in retirement than you are now. However, if you’re looking to minimize your present-day tax burden, traditional 401(k) plans may be better for you.
How to open a solo 401(k)
Starting a solo 401(k) is usually pretty simple. Most top 401(k) providers allow you to quickly start an account online, and since you'll have no employees to register, there's not much setup required beyond linking your bank accounts.
However, unlike SEP IRAs, you need an employer identification number (EIN) to open a solo 401(k). That’s because 401(k)s are technically always sponsored by an employer, even if that employer – you in this case – doesn't have any employees.
Most companies that offer solo 401(k)s, or other self-employed retirement plans, can walk you through this distinction and explain your options if you don't have an EIN. However, since EINs are free to obtain, you may want to apply for one anyway and wait until you receive your EIN to open your solo 401(k). Once you have your EIN, consult our retirement plan reviews to find the right self-employment plan for your needs.