How Can I Start a Solo 401(k)?

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Updated on Wednesday, January 8, 2020

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Self-employment comes with many perks, but you may think access to a 401(k) plan isn’t one of them. Considering the 401(k) is one of the most powerful and accessible investment accounts available to the American public, not having one can be a pretty big loss.

Good news, entrepreneurs: You can have your freelance cake and eat it too! There is such a thing as a solo 401(k), also known as a personal 401(k), individual 401(k), self-employed 401(k), or — our personal favorites — a solo-k or uni-k. Since the solo 401(k) rules are similar to those that govern traditional 401(k)s, you won’t miss out on the high contribution caps that come with combined employee-employer contributions.

So how does this unique solo retirement plan work, exactly? Who’s eligible, and how much can you contribute overall? Read on to learn more about this Goldilocks investment account for self-employed savers.

Solo 401(k) basics

A solo 401(k) is an investment plan designed to help you save for retirement by “deferring” a portion of your income and allowing it to grow tax-free on the market. This boosts your savings goal in a couple of key ways.

Investing your hard-earned cash takes advantage of the power of compound interest, turning even a small investment into a cushy nest egg down the line. In the short term, you’ll benefit from a tax advantage because 401(k) contributions don’t count toward your total taxable income. The exception to that rule is a Roth solo 401(k), wherein your contributions will be taxed today but won’t be subject to tax when you withdraw them later.

Any self-employed individual or sole proprietor is eligible to open a solo 401(k), and a wide variety of traditional 401(k) custodians also offer solo-k options.

If you’re familiar with the basic workings of a regular 401(k), you already know a whole lot about the solo-k too. According to the IRS, “These plans have the same rules and requirements as any other 401(k) plan.”

However, there are a few key differences in the nitty-gritty details for solopreneurs to keep in mind. Let’s take a look!

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How much can you contribute to a solo 401(k)?

Like regular 401(k)s, solo 401(k)s come with generous contribution caps, making them an appealing option for those looking to aggressively save for retirement. You’ll be able to contribute up to 100% of your earned income, capping out at $19,500 — or $26,000 if you account for the $6,500 “catch-up contribution” available to investors aged 50 or over.

The total contribution cap — including “nonelective contributions,” i.e., the freelancer’s equivalent of employer contributions in a regular 401(k) — is much higher.

Your specific contribution cap must be determined using a “special calculation” based on your “earned income,” which, according to the IRS, is defined as your “net earnings from self-employment after deducting both one-half of your self-employment tax and contributions for yourself.” You can make these calculations using the rate table or worksheets in Chapter 5 of IRS Publication 560, “Retirement Plans for Small Business,” or feed your personal financial data into a contribution calculator, like this one from Fidelity.

No matter how much you earn, the overall contribution limits for a solo 401(k) match those of any other 401(k) plan. For 2020, that cap is $57,000 — or $63,500 for those eligible to make catch-up contributions.

There is one big caveat, however, which can catapult your retirement savings to the next level: the spousal exemption.

If you’re married and your spouse earns income from your business, he or she also can contribute up to the $19,500 elective deferral limit — and you can put in up to another 25% of your compensation as a profit-sharing contribution. That means your total contribution limit could effectively double from $57,000 to $114,000.

Solo 401(k) withdrawal rules

Now that we’re clear about how much money you can put into your solo-k, let’s talk about the most important part: taking it out again.

As is the case with a regular 401(k) plan, there are strict rules governing when you can (and must) make withdrawals, and there are penalties in place for those who withdraw their assets early.

In order to avoid taxes and fees, you must wait until you reach the age of 59 and a half before taking distributions from your solo 401(k) plan. You also may be able to access the money with impunity if you can demonstrate “immediate and heavy financial need,” per IRS rules.

If you do take out early withdrawals without meeting one of the exceptional circumstances, the money will count toward your total taxable income for that year — and will be subject to an additional 10% tax as a penalty. Of course, you’ll also be missing out on the opportunity to allow your money to grow.

Like most retirement plans, the solo-k is subject to required minimum distributions. In general, you’ll need to make your first withdrawal by April 1 of the year following the year in which you turn 70 and a half.

Other retirement accounts to consider

If you’re working for yourself, there are a number of alternatives to the solo 401(k) when it comes to saving for retirement.

An individual retirement arrangement (IRA), is an investment account that allows any individual to save for retirement, regardless of their employment situation. IRAs come in both traditional and Roth varieties. They are easy to set up and available through a wide range of financial institutions.

IRAs provide many of the same tax benefits as 401(k) plans. For instance, traditional IRA contributions may be fully or partially tax-deductible, depending on your circumstances, and while contributions to a Roth IRA are taxed, they are then available for tax-free withdrawal upon retirement.

However, IRAs carry a much lower contribution cap than 401(k) plans — just $6,000 for 2020 (or $7,000 if you’re aged 50 or over).

Another popular option for self-employed individuals is the simplified employee pension (SEP) plan. In a SEP plan, contributions are made by the business only, which means you won’t get a tax break on your personal income. The contributions will, however, count as a business expense, and they are deductible up to 25% of employee compensation.

Although SEP plans carry higher contribution limits than IRAs, the “25% of compensation” clause may drive the limit lower than it would be for a solo-k plan, depending on your income. SEP plans also don’t allow catch-up contributions for savers close to the age of retirement, and there’s no Roth option available.

Whether you work for yourself or someone else, saving for retirement is the foundation of any solid financial roadmap. For those who choose to strike their own path, a solo 401(k) plan is an excellent option for paving the road to retirement.

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