What Is a Solo 401(k)?

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 a 401(k)! Designed for small and privately-held business owners, a solo 401(k) can help you score the coveted company match to boost your retirement savings to match the plans offered by bigger companies.

So, what is a solo 401(k) and how do they work, exactly? Who’s eligible, and how much can you contribute overall? Read on to learn more about this favorable investment account for self-employed savers.

What is a solo 401(k) and how do they work?

Solo 401(k)s go by many names. You might hear them called an individual 401(k) or a self 401(k). No matter the name, they all work the same.

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.

• Compound interest. 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.
• Reducing taxable income. 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), where your contributions will be taxed today but won’t be subject to tax when you withdraw them later.
• Employer match. As the employer, you can match your employee contributions to further boost savings. For example, if you opt for a 3% company match and your employee contributions are $10,000 per year, your company can kick in an additional $300 per year to your savings.

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 individual 401(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!

What are the solo 401(k) contribution limits?

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 $20,500 — or $27,000 if you account for the $7,000 “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 solo 401(k) contribution limits are the same as other 401(k) plan. For 2022, that cap is $61,000 — or $67,500 for those eligible to make catch-up contributions. Make sure you don’t over-contribute to your 401(k), however, as it comes with potential steep penalties.

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 $20,500 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 $61,000 to $122,000. Learn more about maxing out your 410(k) to get the most out of your solo-k plan.

What are the solo 401(k) withdrawal rules?

Now that we’re clear about how much money you can put into your individual 401(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 individual 401(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.

Are there 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 2022 (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.