If you are a freelancer, an independent contractor, or a self-employed individual, you know the perks of working for yourself, but you likely also notice one major drawback: the lack of an employer-sponsored retirement plan like a 401(k). Enter the Solo 401(k) plan. Below we’ll discuss how this plan provides the highest savings potential for solo business owners.
What is a Solo 401(k) Plan?
A solo 401(k) is a tax-advantaged retirement account for self-employed business owners as well as spouses who work for them at least part-time. Individuals who hold a full-time job with access to workplace retirement plans are also permitted to save for retirement in a solo 401(k) with funds earned from a side hustle. A solo 401(k) is also referred to as an individual 401(k), one-participant 401(k) plan, or a self-employed 401(k).
Eligibility Rules and Contribution Limits
There are no age or income restrictions with a 401(k), but you must be a business owner with no employees (apart from a spouse). You may be able to contribute up to $61,000 in 2022 (up from $58,000 in 2021). If you are 50 or older, you can make an additional $6,500 in catch-up contributions.
Solo 401(k) Tax Advantages
With a solo 401(k) you can pick your tax advantage: a traditional 401(k) or a Roth solo 401(K).
- Traditional solo 401(k): Contributions reduce your income in the year they are made, which reduces taxable income. However, distributions in retirement will be taxed as ordinary income. You may owe a 10% penalty in addition to ordinary income taxes on withdrawals you make from a traditional solo 401(k) before age 59 ½.
- Roth solo 401(k): Offers no initial tax break but allows for tax-free distributions in retirement. You may be subject to penalties on withdrawals before age 59 ½.
Generally, if you expect your income to increase in retirement, a Roth solo 401(k) is the better option. If you expect your income to decrease in retirement, go for for the tax break now with a traditional 401(k).
How to Open a Solo 401(k)
If you decide to set up a solo 401(k), you can do so through a financial institution that administers 401(k) plans. Set-up typically follows these steps:
- If you don’t already have one, you need to get an Employer Identification Number (EIN) from the IRS.
- Choose a provider. When reviewing potential plan administrators, look into any applicable fees. You many also want to look for a plan that offers a mix of investment options, including mutual funds, stocks, bonds, ETFs, and CDs.
- Fill out an application and any required documents. The IRS requires an annual report on Form 5500-SF if your 401(k) plan has $250,000 or more in assets at the end of a given year.
- Once you are ready to fund the account, you can roll over money from another retirement account or set up a transfer from a checking or savings accounts.
- Finally, choose your investments and establish contribution levels. Keep in mind that there is no minimum contribution requirement, so you can increase contributions in good years and save less in years when you need more cash reserves for your business.
With high contribution levels, flexible investment options, and fairly easy administration, the solo 401(k) could be a good fit for a one-person business operation, freelancer, or independent contractor, especially if you want the option to save aggressively for the future.
