An Overview of Solo 401(k) Plans
posted by Fisher 401(k) July 27, 2020 Updated
What is a Solo 401(k) plan?
A solo 401(k), also known as an individual 401(k), solo(k), or self-employed 401(k), is a special type of employer-sponsored retirement plan specifically designed for self-employed individuals with no employees. With over 23 million sole proprietorships in the United States, this self-employed 401(k) plan type offers entrepreneurs a unique opportunity to save for retirement while enjoying many of the same benefits of traditional 401(k) plans.1
Who is eligible for a solo 401(k)?
To be eligible for a solo 401(k) plan, an individual must be self-employed and have no employees. Solo 401(k) plans are ideal for sole proprietors who are concerned with tax mitigation and increasing their ability to save for retirement. Often, self-employed individuals who are frustrated by the low contribution limits of IRA plans turn to self-employed 401(k) plans in order to increase the amount of income they can save and invest tax-deferred for retirement.
Solo 401(k) vs. SEP IRA: What’s the difference?
A solo 401(k) is different from individual retirement accounts (IRAs) because it has more features, including increased contribution limits. And while there are many forms of IRAs available, the Simplified Employee Pension (SEP) IRA has long been the default retirement planning tool for “solopreneurs.” SEP IRAs are low-cost, carry a relatively low administrative burden, and have higher contribution limits than standard IRAs—but they still lack many of the attractive features and benefits of a solo 401(k) plan.
What are the solo 401(k) rules?
Because solo 401(k) plans are truly 401(k) plans, solo 401(k) rules are mostly the same as traditional 401(k) plans. One key difference is that in a solo(k), a self-employed individual acts as both employer and employee, meaning they need to think about their contributions both in terms of employee and employer contributions. With solo(k) plans, you can save up to the normal employee 401(k) contribution limits of $20,500 in 2022 or $27,000 if age 50 or over plus employer contributions of up to 25% of qualified income. Combined, these two annual contributions are subject to the same $58,000 total limit (or $67,500 if age 50 or over).
There are two additional differences that make solo(k) plans simpler than traditional 401(k) plans: 1. Self-employed 401(k) plans are not subject to nondiscrimination testing. Since there is only one employee, there’s no chance for an employee to unfairly benefit over another in the plan, hence no need for testing. 2. Solo(k) plans do not file Form 5500 until the plan assets are $250,000 or greater, whereas a traditional 401(k) plan has to file Form 5500 regardless of asset size. Otherwise, an individual 401(k) plan is subject to all the same rules, regulations, and benefits as traditional 401(k) plans.
What are the benefits of a solo 401(k) plan?
In addition to increased contribution limits over SEP IRAs, solo 401(k) plans offer self-employed individuals many of the same benefits of a traditional 401(k), including easy plan conversions, Roth options, loans, and additional saving opportunities with Cash Balance. Below each of these benefits are highlighted:
More Flexible Employer Contributions
Because solo 401(k) plans can easily be converted into full 401(k) plans, they offer you as an employer more flexibility in terms of offering contributions to any employees you may hire as your business grows. This contrasts with a SEP IRA, which offers no options for profit sharing contributions and sets the rate of employer contributions at the plan level. For example, if you set up a SEP IRA for yourself and choose to give yourself the full 25% employer contribution, you will need to offer the same 25% contribution to any future employees who join the plan.
Flexible Option for Roth Contributions
Roth contributions can be a good option for individuals early on in their career who would rather pay taxes on their retirement savings now than in retirement when they may be in a higher tax bracket. Solo(k) plans give you the option to make traditional pre-tax contributions or post-tax Roth contributions. A SEP IRA doesn’t allow for Roth contributions. Having the option to make pre-tax and/or Roth contributions gives solo(k) participants more flexibility to diversify the tax treatment of their retirement savings.
Solo 401(k) Loans
Solo(k) plans give you the option of allowing 401(k) loans just like any other 401(k) plan. On the other hand, SEP IRAs do not allow for loans.
Solo 401(k) and Cash Balance Pairing
For many self-employed individuals making $250,000 or more per year, tax mitigation becomes a primary concern. Retirement plans can help individuals keep more of their money today so it can grow for retirement, and that power is only increased when a retirement plan is paired with a cash balance plan. A solo(k) can be set up with a cash balance plan to empower solopreneurs to put away up to an additional $250,000 per year in pre-tax retirement savings.2
Spouses Can Join Individual 401(k) Plans
Despite the name, one of the unique benefits of a solo(k) is the ability to add a spouse to the plan and still have it be considered an individual 401(k) plan. If you are a married sole proprietor your spouse can also be included in the solo(k), so long as they receive income from the business. This allows your spouse to save up to $20,500 (or $27,000 if over 50) and receive employer contributions, increasing your family’s overall ability to save for retirement.
How do I set up a solo 401(k)?
Setting up a solo 401(k) plan is in many ways just like setting up a traditional 401(k) plan. Many 401(k) providers double as solo 401(k) providers and offer custom-tailored retirement plans just for self-employed individuals. For example, with Fisher Investments 401(k) Solutions, an individual 401(k) can get access to all the high-quality funds and retirement planning support enjoyed by any other employer offering a traditional 401(k) plan, with a special focus on the needs and goals of sole proprietors. Contact us today to learn more about setting up or upgrading your own individual 401(k) plan.
2Assumes annual 401(k) maximum contribution of $20,500; $6,500 catch up; $37,500 profit sharing (for 2022)