A solo 401(k) is one of the best retirement plans for self-employed individuals. It offers higher contribution limits and exemptions from annual nondiscrimination testing.
The money you contribute to a traditional solo 401(k) reduces your taxable income and grows tax-deferred until withdrawals are made in retirement. Withdrawals before age 59 1/2 are subject to regular income taxes and a 10% penalty.
Tax-Efficient Savings
A solo 401k is one of the most tax-efficient retirement savings vehicles for self-employed individuals. It offers the same tax advantages as a traditional 401(k), but it allows you to save up to 25% of your net adjusted self-employment income. This is minus your employer contributions and your employee catch-up contribution, if applicable.
The IRS limits the maximum contribution amount to a solo 401(k) as both an employee and employer, so it’s essential to choose a plan provider to ensure you will stay within these limits. In addition, you’ll want a provider that has extensive experience in administering these types of plans.
Depending on your business structure, there are several different options for opening a Solo 401(k). For example, sole proprietors and independent contractors can open a self-employed 401(k) or individual 401(k), while C-corporations can use a safe harbor 401(k).
You’ll also want to consider the investment choices offered by a plan provider. Look for options that can invest in a wide variety of alternative and more traditional investments. And remember, it’s essential to find an investment firm with a track record of solid returns over time. That way, you’ll be able to diversify your portfolio and minimize your risk of exposure to a single market downturn.
Tax-Free Withdrawals
A solo 401k is one of the most tax-efficient retirement options for the self-employed. You can take out funds from your account without penalty or taxes after age 59 1/2. You can also convert your account into a Roth solo 401k, allowing you to make tax-free withdrawals in retirement.
The traditional solo 401k allows you to deduct employee contributions from your taxes, just like a workplace 401(k). It also allows you to contribute as an employer and set up profit-sharing contributions. It is a better choice than a SEP IRA because it does not require an annual nondiscrimination test for employees, but it does have the same contribution limits as other traditional 401(k)s.
Those who qualify for a Solo 401k include sole proprietors, independent contractors, limited liability companies (LLCs), and partnerships that engage in a trade or business to earn income. Some common examples of qualifying businesses include financial advisors, real estate agents, physical fitness trainers, and adult care providers.
The maximum annual contribution limit equals 100% of your net adjusted self-employment income or $22,500 in 2023, whichever is less. An additional catch-up contribution amounting to $7,500 can be made by individuals aged 50 and older. Unlike a SEP IRA, you can’t take out a loan from your solo 401(k). However, if you are in financial hardship, you may be eligible for a hardship withdrawal that does not trigger an early withdrawal penalty.
Alternative Investments
A Solo 401k is an excellent retirement plan option for the self-employed. It was made available in 2001 due to the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). Before that, self-employed individuals were limited to a profit-sharing plan that did not include employee deferral options.
A solo 401(k) allows you to make employer and employee contributions, like a workplace 401(k) or traditional IRA. The account holder can also choose between a Roth or pretax solo 401(k), which impacts how the account will be taxed.
Alternative investments, known as “non-securities,” are often allowed in Solo 401ks. These include real estate, private mortgages, physical gold and silver, equity in a business or franchise, physical rental properties, personal loan notes, and more. Investing in alternative assets through a Solo 401(k) offers more investment opportunities than traditional funds.
One of the best benefits of a solo 401k is that it is typically open at a brokerage firm, giving you more investment choices than a traditional employer-sponsored plan provider like Fidelity or E*TRADE. Plus, many brokers offer low or no transaction fees on stocks and ETFs and don’t charge a monthly account fee. This is an essential factor when choosing a retirement plan provider. It can help you save more in the long run because your investments are less likely to be eroded by excessive trading fees.
Easy to Set Up
When you shop for a Solo 401k, choose a provider that offers a straightforward signup process, a user-friendly investment tracker, and a simple transfer process. You don’t want to work with multiple providers to get your retirement account up and running or to keep tabs on your investments.
Look for a provider that offers a variety of investment options, including alternative investments. It would help if you also looked for a provider that allows you to roll over or transfer outside retirement accounts, such as traditional 401(k)s from former employers and IRAs.
Finally, an excellent solo 401k provider should offer support via phone or email and have a clear understanding of the rules and regulations. It would help if you were wary of providers unclear about their fees, don’t have a Better Business Bureau page, or otherwise appear to focus more on sales than customer service.
You can start a Solo 401(k) at most online brokers, though you’ll need an Employer Identification Number (EIN). Once you have your EIN, you can open the plan and set up contributions. You can invest your employee deferrals, employer profit-sharing contributions, and catch-up contributions in index funds, mutual funds, exchange-traded funds, and individual stocks and bonds. You can even use the services of a financial advisor to manage your retirement account if you need more time to handle the assets yourself.
