What is a Self-Employed (Solo) 401(k)?

What is a Self-Employed (Solo) 401(k)?

You’ve likely heard of a 401(k) plan. However, you may be unfamiliar with its solopreneur variation – the self-employed (solo) 401(K).

The solo 401(k) can be an ideal retirement account for the right type of business owner. Its benefits are numerous, and it can allow you to save substantial amounts of money in a tax-advantaged way.

In this article you’re going to learn what a solo 401(k) is, who it’s best suited for, its advantages and disadvantages, and how you can start using one yourself.

What is Self-Employed (Solo) 401(K)?

A self-employed (solo) 401(k) is a retirement plan specifically designed for business owners with no employees.

Solo 401(k)s operate just like regular 401(k)s. Your money is placed inside a retirement account and is invested in a range of mutual funds or target-date funds based on the securities and bonds of your choosing. Additionally, like their regular alternative, solo 401(k)s also come in Roth and traditional varieties.

Who Qualifies For A Solo 401(K)?

By IRS rule, to invest in a solo 401(K) you must be a business owner with zero employees. However, an exception can be made in the case of a spouse. If you employ your marital partner, both of you can still participate in a solo 401(k) plan.

There are no limitations in regards to age or income when opening your solo 401(k) account. However, there are multiple IRS guidelines that you must abide by to continue using one. These guidelines include contribution limits, early withdrawal penalties, and required minimum distributions.

What Are The Rules For A Solo 401(K)?

Contribution Limits: For 2023, it’s possible to contribute up to $66,000 to your solo 401(k) as long as you meet the proper IRS criteria. Additionally, participants ages 50 and older can contribute even more with 2023’s catch-up contributions of $7,500.

Early Withdrawal Penalties: Taking money out of your solo 401(k) before age 59½ may trigger unwanted taxes and penalties. You may be subject to a 10% early withdrawal penalty, and be required to pay taxes on the income you receive.

Required Minimum Distributions: Solo 401(k)s come with required minimum distributions (RMDs). This means you’ll have to start taking money from your account when you reach the age of 73.

Pros And Cons For A Self-Employed 401(K)?

Pros

1. Tax-Advantaged Contributions and Withdrawals

When you use a traditional solo 401(k), you’re able to deduct your contributions, earn tax-deferred interest, and pay ordinary income taxes on your withdrawals. However, with the Roth variety, you fund your solo 401(k) with after-tax money. This means you’re able to eventually make your withdrawals tax-free.

2. Double-Sided Contributions

With solo 401(k)s you contribute to your account as both an employer and an employee. These double-sided contributions aren’t allowed with all retirement vehicles.

3. Larger Contribution Limits

A huge benefit of solo 401(k)s are their higher contribution limits. Compared to other account types (ex: traditional and Roth IRAs), you’re able to put in substantially more each year, and that extends to the catch-up contributions you can make when you’re age 50 or older.

4. Versatility

Solo 401(k)s come in both traditional and Roth varieties.

5. Borrowing Perks

Solo 401(k)s allow you to borrow $50,000 or 50% of your account’s value (whichever is less) for any reason. You’ll just have to pay it back within 5 years (30 years if it’s used to purchase a primary residence).

Cons

1. No Employees

Other than your spouse, you cannot have any employees while participating in a solo 401(k). So if you have employees, or plan to hire some down the road, you’ll need to find another way to save for retirement.

2. Consistency Requirement

Contributions to your solo 401 (k) must be seen as “recurring and substantial” in the eyes of the IRS. Generally speaking, that means you must contribute a significant enough amount on a regular enough basis to show that you plan on continuing to use the plan. Otherwise, your plan will be seen as discontinued and terminated.

3. Form 5500 Filing Requirement

If your solo 401(k) account has assets totaling $250,000 or more by the end of the year, the IRS generally requires you to file an annual report on a Form 5550-EZ.

How Do I Set Up A Solo 401(K)?

You’re able to create a Solo 401(k) through most brokerage firms (ex: Fidelity). The brokerage will then offer an array of investment options for you to choose from. Additionally, you’ll be able to establish a vesting schedule which determines how much, and how often, you’re investing in your retirement plan.

Please Note: You don’t have to figure this out on your own. Schedule your free call with us, and we can get started on identifying the investment strategy that’s best for you.

How Can Fisher Investments Help You?

At Fischer Investment Strategies – Retirement Services, we help our business-owner clients prepare for retirement in the way that is best for them.

For those who are self-employed, or only employ their spouse, solo 401(k)s present a powerful way to save for the future. Their higher contribution limits, tax-sheltering, and borrowing allowances can be leveraged together to build wealth quickly and tax-efficiently.

If you’re interested in learning more about solo 401(k)s, or want to get started investing in one of your own, we’re here to help. Please don’t hesitate to reach out to our Westlake office at (805) 418-7686. You can also fill out a contact card, and we’ll reach back out to you.

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Pierre Gendreau is an Investment Advisor Representative with over 20 years of Financial Services experience. In 2000, Pierre graduated from the University of California, Irvine with a bachelor’s degree in Research and Analytical Methods.

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