Solo 401(k) plans: A guide for self-employed small business owners
Presented by Chase for Business
Quick insights
- A solo 401(k) is a retirement savings plan designed specifically for self-employed individuals and small business owners with no full-time employees, or that person and their spouse.
- Contribution limits allow participants to save as both an employee and an employer.
- Setting up and managing a solo 401(k) involves specific eligibility criteria, contribution rules and withdrawal guidelines.
When it comes to planning for the future, self-employed professionals may face a unique challenge: How do you save for retirement without the benefit of a corporate program?
Whether an individual is a high-earning independent consultant looking to lower their tax bill, a couple running a business trying to catch up on retirement savings or a scaling freelancer wanting to start a consistent savings habit, a solo 401(k) may offer a flexible solution.
This guide explains what a solo 401(k) is, who generally qualifies, how much you can contribute and how these accounts are typically set up. You may want to consider consulting with a tax professional about your specific situation.
Let’s dive in.
What is a solo 401(k)?
A solo 401(k)—also known as an individual 401(k) or self-employed 401(k)—is a retirement savings plan created specifically for business owners with no employees other than a spouse. It combines the familiar features of a traditional corporate 401(k) with the flexibility often desired by self-employed individuals.
A notable feature of this plan is that it allows contributions in two capacities—as an employee and as an employer. These plans also may offer tax advantages. Participants can often make pre-tax contributions to reduce their current taxable income, enjoy tax-deferred investment growth or, in many cases, choose a Roth option to make after-tax contributions with the potential for tax-free growth.
Who can have a solo 401(k)?
Eligibility is generally limited to self-employed individuals or small business owners who meet two main criteria:
- Business ownership with earned income: The individual needs to own a legitimate business that generates earned income. This includes sole proprietorships, partnerships, LLCs and corporations.
- No full-time employees: The business generally cannot have any full-time employees (those averaging 30 hours per week, or 130 hours of service per month) other than the owner and their spouse. Part-time employees usually do not disqualify a business, but full-time employees typically do.
If a business grows and eventually hires a full-time employee, it may no longer qualify for a solo 401(k) and may need to transition to a small business 401(k) plan.
Contribution limits for solo 401(k) plans
The ability to contribute as both employee and employer is part of what makes the solo 401(k) a popular option. Here is how the IRS limits break down:
- Employee deferral: This is the individual's contribution to the account. Participants can contribute up to 100% of their earned income or the set maximum (whichever is less). Those who are 50 or older can make an additional catch-up contribution.
- Employer contribution: This is the business's contribution. The business can make an additional profit-sharing contribution of up to 25% of net business earnings. For sole proprietors and single-member LLCs, calculating this 25% requires deducting half of the self-employment tax and the individual's own plan contributions, which effectively makes the maximum employer contribution about 20% of net earnings.
There is also a total maximum contribution that is the combined total of employer and employee contributions that cannot be exceeded. This amount is higher for individuals who are 50 or older.
Contribution limits may change annually, so refer to IRS guidelines for the most current maximum contribution amounts.
How and when to withdraw funds
Withdrawals from a solo 401(k) follow rules similar to other qualified retirement plans. There are age and tax considerations that factor into withdrawing funds from a solo 401(k), including:
- Age 59½ and older: Participants can generally begin taking penalty-free withdrawals once they reach age 59½. Traditional pre-tax withdrawals are subject to ordinary income tax, while qualified Roth withdrawals may be tax-free.
- Loans and emergencies: Some solo 401(k) plans allow participants to take a loan from their account (with limits) in the event of a cash-flow emergency. The loan is typically paid back to the account with interest.
- Required Minimum Distributions (RMDs): Starting at age 73, account holders are generally required to take RMDs from traditional solo 401(k) accounts.
Withdrawals may face additional taxes or penalties if they happen for reasons not allowed by the IRS. For example, taking distributions before age 59½ usually results in a 10% early withdrawal penalty plus income tax, unless an IRS exception applies. Consult IRS guidelines for more information and current guidelines.
How solo 401(k)s are typically set up
Establishing a plan usually involves a few specific administrative steps. Most individuals will need an Employer Identification Number (EIN) to open a solo 401(k). You’ll also need to choose a provider who offers solo 401(k)s.
Your provider will typically require documentation to open the account as well as a signed adoption agreement. This generally needs to be completed by December 31st of the year when the individual wants to start making employee contributions.
Solo 401(k) vs. SEP IRA
When researching self-employed retirement plans, many consider the solo 401(k) and Simplified Employee Pension (SEP) IRA. A SEP IRA is another common retirement account that allows business owners to contribute a portion of their income toward retirement.
While both may offer tax advantages, they function differently:
- Contribution types: A SEP IRA only allows employer contributions (up to 25% of net earnings) whereas a solo 401(k) allows both employer contributions and employee deferrals.
- Catch-up contributions: SEP IRAs do not allow catch-up contributions.
- Roth options and loans: Solo 401(k)s often permit Roth (after-tax) contributions and may allow participants to take a loan against their balance. SEP IRAs are typically pre-tax and do not permit plan loans.
A solo 401(k) may be beneficial for those whose primary goal is to maximize their savings, want the potential flexibility of a plan loan or want to make Roth contributions. A SEP IRA is frequently selected by individuals who already have full-time employees or plan to hire full-time employees in the near future.
Frequently asked questions
Can funds from other retirement accounts be rolled over into a solo 401(k)?
Yes. Many solo 401(k) plans accept rollovers from previous employer 401(k)s, 403(b)s and Traditional IRAs. Many individuals use this feature to consolidate their retirement accounts.
Are annual contributions required?
No. Solo 401(k) contributions are generally discretionary. If a business has a slow year, the owner can often choose to reduce contributions or skip them entirely without penalty.
Are solo 401(k) contributions tax deductible?
Employee contributions to a traditional solo 401(k) may reduce personal taxable income for the year. Employer contributions are typically deductible as a business expense. If an individual chooses to make Roth employee contributions, those are made with after-tax dollars and do not provide a current-year deduction, but they have the potential for tax-free growth.
