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Retirement, Small Business

A Comprehensive Guide to the Solo 401(k) for Business Owners

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

If you run your own business, one of the difficulties in saving for retirement is that you don’t necessarily have easy access to a 401(k).

Enter the solo 401(k). This is a retirement savings option for self-employed business owners who have no employees and their spouses. Read on to find out how it works, who is eligible, and how you can open an account.

The Solo 401(k): Explained

What Is a Solo 401(k)?

Also known as a one-participant or individual 401(k), a solo 401(k) works just like a company-sponsored 401(k) would, except it’s for self-employed individuals who don’t have any other employees other than their spouses and themselves.

Just like a traditional 401(k), you can control how your money is invested. There are different plans, with most comprising stocks, bonds, and money market funds. These are considered “free” prototype plans offered by brokerages, and you’re typically limited to investments offered by that brokerage.

However, there are options for those looking to participate in alternative investments, such as precious metals or even real estate. There are companies that help you open what’s called a self-directed 401(k) and that sponsor “checkbook control” solo 401(k) plans, meaning that individuals can control the type of investments they want to make, whether it’s stocks, bonds, foreign currency, real estate, or commodities. You do so by writing a check for investment purchases, from a bank account dedicated specifically for that purpose.

Who Is Eligible for a Solo 401(k)

Only self-employed individuals and their spouses are eligible for a solo 401(k). This plan is ideal for consultants, independent contractors, or sole proprietors. If you hire part-time workers or contractors, then you’re still safe. However, if they work for you for more than 1,000 hours a year, you cannot participate in a solo 401(k).

Furthermore, you need to have the presence of self-employment activity to be eligible, which includes ownership and operation of an LLC, C, or S corporation, a sole proprietorship, or a limited partnership where the business intends to make a profit. There are no criteria as to how much profit a business needs to generate, as long as you run a legitimate business with the intention to generate a profit.

If you are currently employed elsewhere, you can still open a solo 401(k) account if you’re serious about maximizing your pre-tax savings. If you work for an employer that offers a 401(k) plan, you can still participate in their plan alongside a solo 401(k) plan, as long as you don’t exceed the contribution limits.

Where to Open a Solo 401(k)

You can open a solo 401(k) with most major brokerages. For those looking for a custom plan, there are companies that specialize in providing those plans. Some insurance companies also offer solo 401(k) plans but only if your goal is to invest solely in annuities.

Below are some of the most popular companies offering solo 401(k) plans:

Vanguard – The individual 401(k) offers all Vanguard mutual funds. However, you cannot purchase exchange-traded funds (ETFs) or mutual funds from other companies and cannot take out a loan. There is no setup fee, but there is a $20 fee per account per year to maintain your solo 401(k).

SunAmerica – The SunAmerica Individual(k) offers mainly annuities as part of their plan. You can take out a loan (for a fee). It costs $35 to set up your account, and there is an annual maintenance fee of $75.

E-Trade – The E-Trade Individual 401(k) Plan allows Roth contributions and has a brokerage option with $9.99 trades for any ETF. They accept IRA rollovers and allow for loans. They also will pay you if you transfer your current solo 401(k) to them: $200 for $25,000-$99,000, $300 for $100,000-$249,000, and $600 for a $250,000+ plan.

How to Establish a Solo 401(k)

When opening a solo 401(k) plan, you want to choose the option best for your needs. Once you’ve selected your brokerage, you’ll need to have the necessary documents:

  • 401(k) plan adoption agreement
  • Designation of successor plan administrator, which requires a notary or a witness
  • Brokerage account application
  • Designation of beneficiary form
  • Power of attorney (optional)

If you plan on opening one for your spouse, you’ll need to do twice the paperwork (one form for each person).

Remember, you need to open a solo 401(k) account by December 31 of the tax year. You don’t need to actually fund it until the April 15 filing deadline. If you miss opening an account, you’ll have to wait until the next tax year to do so.

How Much You Can Contribute to a Solo 401(k)

Participants in a solo 401(k) plan can make contributions both as an employee and an employer.

For elective (employee) contributions, you can contribute up to 100% of your earned income, up to the annual contribution limit, which is $18,000 in 2017. Those age 50 or older can contribute an additional $6,000, depending on the type of plan, according to the IRS.

When making a contribution as an employer, you can contribute up to 25% of your earned income as an employee. Your total contributions cannot exceed $54,000 in 2017 ($53,000 for 2016), not counting extra contributions for those 50 or older.

For example, Mary earned $40,000 from her freelance business in 2016. She put $18,000 in this plan as an employee. As an employer, she contributed 25% of earnings, which is $10,000. In total, she contributed $28,000, which is the maximum she can contribute.

Remember, contribution limits are for each person, not each plan. If you are working full time for another employer and participate in that company’s 401(k) plan, combined contributions to your traditional 401(k) and solo 401(k) cannot exceed the annual limit.

To figure out the maximum contributions you can make, check the IRS website on how to calculate a more accurate amount.

Read more: 9 Essential Tax Tips for Entrepreneurs >

Learn More About Solo 401(k)s

The Pros of a Solo 401(k)

The solo 401(k) has higher contribution limits compared to other retirement savings plans. You can contribute up to $18,000 plus 25% of earned income, compared to a maximum of $54,000 or only 20% your earnings (whichever is less) with a SEP IRA. Your employer contributions are also tax deductible.

You also have the option to borrow up to 50% of your account’s value or $50,000, whichever amount is less.

The Cons of a Solo 401(k)

A solo 401(k) can get complicated to set up and maintain, particularly if you intend on opening a customized plan. Depending on the company you go with, fees can cost you at least a few hundred dollars to set up an account, not including fees to maintain the plan annually.

Even if you open a prototype plan, it can cost you. Yes, it’s free to set up, but they put many requirements on you as the owner. These requirements include filing tax return documents once a year if your plan has more than $250,000 in assets and keeping up to date with all records and transactions.

Alternatives to a Solo 401(k) Plan

There are two alternatives to a solo 401(k) plan — a SIMPLE IRA and a SEP IRA. The main difference between each is the maximum amount you can contribute to each year.

SIMPLE IRA – A Simple IRA plan is for those who as an employee (including those who are self-employed) have earned a minimum of $5,000 any two years before the current calendar year and expect to receive at least $5,000 for the current calendar year. You can contribute up to $12,500, plus an employer match of 3% of employee compensation. Those 50 or older can also contribute up to an extra $3,000. You can find more information about the simple IRA on the IRS website.

SEP IRA – A Simplified Employee Pension (SEP) plan only allows employers to contribute to the plan, unlike a solo 401(k). Employers can contribute a maximum of $53,000 or 20% of their net self-employment earnings, whichever amount is less.

Even with all its benefits, there may be a few reasons why someone is better off not opening a solo 401(k). “If you’re concerned about doing additional paperwork, a SEP IRA might also be a better choice,” advises Robert Farrington, founder of the College Investor. “If you’re working a side hustle and have a regular 401(k) at your day job, the alternatives might be easier.”

Who Solo 401(k) Plans Are Best For

While any of the above options are helpful for self-employed individuals, the solo 401(k) is best for those who are looking to invest heavily in their savings. “The solo 401(k) is best suited for a self-employed individual who wants to maximize their retirement savings,” says Farrington.

“Furthermore, if you’re a husband/wife/spouse team, your spouse can also contribute to the solo 401(k) with the same percentage of ownership, so you can get even more in tax savings and retirement contributions.”

Sarah Li Cain
Sarah Li Cain |

Sarah Li Cain is a writer at MagnifyMoney. You can email Sarah Li here

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