What Is a Solo 401(k)?

It's easier than ever to start your own business, but with self-employment comes many hurdles, including the lack of an employer-sponsored retirement plan.

About 16 million Americans work for themselves, according to recent data from the Pew Research Center. One of the biggest issue facing these Americans is the lack of an employer-sponsored retirement plan. When you are the boss and the employee, there's no pre-set company 401(k) plan to sign up for. There's no company match.

However, there are retirement-specific accounts available for self-employed people, and one is called a solo 401(k).

What Is a Solo 401(k)?

A solo 401(k) is a 401(k)-style account designed for small business owners or self-employed people with no employees. The IRS also calls it a “one-participant plan” or a “self-employed 401(k) plan.”

A solo 401(k) is good for people who:

• have no employees
• have an employer identification number

These plans are governed by the same rules as an employer-sponsored 401(k) plan. That means there are contribution limits (though a different contribution limit) and penalties and fees for early withdrawals. Your brokerage may limit the types of investments you can buy through your plan.

An important and exciting thing about a solo 401(k) is that your spouse can be covered by the plan. If your spouse earns money from your business, then they can be counted as a plan participant. This essentially gives you the chance to double your contributions to the plan, which could mean huge retirement savings. Spouses are the only people able to be covered by a solo 401(k).

How to Open a Solo 401(k) Account

Opening up a solo 401(k) is easy, since you are the only one on the account. If you want to set up an account, follow these simple steps.

1. Figure out if you are eligible for a solo 401(k). If you are self-employed or own a business and have no employees, then you are qualified. If you want to grow your business in the future, keep the single participant rule in mind.
2. Find a solo 401(k) provider. Once you have decided if you want to open an account, you need to find a provider that meets your needs. Setting up a solo 401(k) is different than when a company sets up a traditional 401(k) or SEP IRA. Keep in mind things like cost, reputation, and investment flexibility. Blooom and Empower are robo advisors that handle solo 401(k)s and it's easy to set up an account with them.
3. Complete the required paperwork. Setting up a solo 401(k) requires a bit of paperwork. Your provider should be able to walk you through all the documents needed.
4. Prepare employee disclosures.  Even though you are the only participant in the account, you will need to have a disclosure document outlining the plan and benefits of tax-free savings. This is because if you ever hire employees, your account will automatically transfer to a Traditional 401(k) and be subject to disclosure rules.
5. Open an account. This is the easy part. Create an account with your chosen provider prior to the tax-filing deadline.
6. Fund your account. Once you open an account, you can start making contributions from your bank account. However, there are limits to how much you can contribute to your account each year, which we outline below.

Solo 401(k) Contribution Rules and Limits

Normally, employer-sponsored 401(k) plans have a $19,000 individual contribution limit for 2019 and a $19,500 limit for 2020. The solo 401(k) contribution limit is different.

With a solo 401(k), you are both the employee and the employer. So you can contribute to the plan via each role. That means that your total contribution limit can be much higher than with a traditional 401(k).

• The total contribution limit is $66,000 for 2023, this includes both the employee and employer contributions
• Plan owners who are 50 years old or older are allowed to make an additional $7,500 for 2023 contribution. This is a catchup contribution, designed to help those who got a late start on investing.

2023's $66,000 (or $73,500 if you're at least 50 years old) breaks down like this:

• As an employee, you can contribute up to $22,500 (or $30,000 if at least age 50) but no more than 100% of your pay. If you are eligible to make that catchup contribution, you would make it as the employee.
• As the employer, you can also make a profit-sharing contribution of up to 25% of your net self-employment income. The IRS does have a limit on the amount of income that can be used to determine your net self-employment income. It's $330,000 for 2023, which means that anything you makeover that cannot be counted toward your solo 401(k).

This Limit Applies to All of Your 401(k) Plans

Something to note is that while the government wants to encourage people to save and invest for retirement, it doesn't want you to tuck too much money away with tax benefits. So it decided that the personal contribution limit of $22,500 (or $30,000 if age 50 or older) applies to all the 401(k) plans you're in.

That means that if you start your own business as a side hustle and open a solo 401(k) and you have a 401(k) at your regular job, you can only contribute a total of $19,500.

You can, for example, put $13,000 into your workplace plan and $9,500 into your self-employed 401(k) plan, but you cannot put $22,500 into each plan.

Another note is that as your investments grow in a self-employed 401(k) plan, the rules change a little. For example, a plan that has $250,000 or more in assets at the end of the year is generally required to file an annual report on Form 5500-SF. Check with your financial advisor for other requirements that may apply to your plan.

Is a Solo 401(k) Good for You?

These plans are good for:

• People with no employees
• Someone who makes enough from their business to contribute to a retirement plan
• People with a spouse who earns money from the business
• Someone who works full time in their own business

These plans might not be best for:

• Companies with employees or that will soon have employees
• Someone who works part-time at their own business

Solo 401(k) Allows You to Pick Your Tax Status

One interesting thing about a solo 401(k) is that when you open the account, you can pick your tax status. If you open a traditional solo 401(k), you elect to have your contributions not taxed when you make them. In this case, you can deduct your contributions from your taxes, and then you would pay tax on your investments when you withdraw the money in retirement.

With a Roth solo 401(k), you elect to pay the tax when you make the contributions and pay no tax when you withdraw money in retirement. However, with a Roth solo 401(k), you cannot contribute to the profit-sharing percentage.

It's nice to have the flexibility to choose which type of account you'd like to open. For many small business owners, the first few years the business doesn't make a lot of money, and a Roth option is nice to have.

Save for Retirement No Matter What

Solo 401(k) plans can be retirement savings powerhouses. They operate like a workplace-sponsored 401(k) plan, including paying fees and penalties for taking money out before you are 59½ years old and having to make your contributions on the calendar year, not the tax year like with IRAs. Since solo 401(k) plans cannot be opened by companies with employees, some business owners could find it too restrictive for their needs.

But for small business owners who want to invest for retirement while working for themselves, the solo 401(k) is an attractive option and a great way to build up your nest egg.