10 Facts About Solo 401(k) Retirement Accounts You Should Know
A solo 401(k) is a great retirement savings option for the self-employed. These critical facts can help you use the account wisely and save much more.
Brady H., a member of my Dominate Your Dollars Facebook group, recently posted some great questions. He says:
“I had an LLC, in which I was the sole owner, and I opened a solo 401(k) and a solo Roth 401(k). But I changed the business to an S corporation, and I hired my girlfriend as a non-paid employee. Can I still have the solo 401(k)s even though I have an employee? Also, do my contributions for the current year need to be in the account by April 16 or just requested by then?”
Brady, thanks for your posts in the DYD group! A solo 401(k) is a fantastic retirement plan for a solopreneur, but it comes with some unique rules. In this post, I’ll answer Brady’s questions and explain 10 facts about using a solo 401(k), so you can save more for retirement.
10 facts about solo 401(k) retirement accounts
Before using a solo 401(k), make sure that you understand the following facts.
1. Eligibility is generally limited to solopreneurs
A solo 401(k) is a type of retirement plan for the self-employed. It’s also known as an individual 401(k), a one-participant 401(k), and a uni-401(k). It comes with a unique requirement in the world of retirement plans: You can only use it if your business has no full-time employees other than the owner(s) and their spouse(s).
You qualify for a solo 401(k) no matter your profession or business entity, such as a sole proprietor, partnership, limited liability company (LLC), or corporation. You can be self-employed part-time, full-time, or even while you simultaneously work for other employers.
If your spouse works in your business, even as a paid employee, you can still have a solo 401(k), and you and your spouse can both make contributions as owner-employees.
There’s no threshold for how much revenue your solo business must make. As long as you intend to make a profit and don’t have excluded employees on the payroll, you’re eligible for a solo 401(k).
However, be aware of two exceptions to the no-employee rule. One is if your spouse works in your business, even as a paid employee. You can still have a solo 401(k), and you and your spouse can both make contributions as owner-employees.
Another exception is the ability to have part-time employees who work less than 1,000 hours per year. Note that you can have an unlimited number of businesses or other self-employed folks working with you, such as 1099 contractors and freelancers. But once you hire a W-2 employee who works full-time hours, you can no longer contribute to a solo 401(k).
It’s important to keep in mind that self-employment doesn’t need to be your only source of income. For example, if you work a full-time job for an employer and do some consulting work on the side, you can use a solo 401(k) to set aside some of that extra income.
It’s important to keep in mind that self-employment doesn’t need to be your only source of income. For example, if you work a full-time job for an employer and do some consulting work on the side, you can use a solo 401(k) to set aside some of that extra income.
2. Hiring employees freezes your account
You’re probably wondering what happens to your solo 401(k) if you break the no-employee rule. After all, your business needs can change, and you may need to hire full-time workers one day.
Just to review, you can have a solo 401(k) when you have part-time employees or use independent contractors in your business. But once you have a full-time worker on your payroll, you can no longer make any contributions to it. Your plan gets frozen, which means you can still manage it and allow it to grow as-is, but you won’t be able to add new contributions to the account.
But once you have a full-time worker on your payroll, you can no longer make any contributions to your solo 401(k).
You have other options, such as opening a regular 401(k) to offer as an employee benefit. Then you could roll over your frozen plan into the new 401(k) and cancel the old account. Or you and any other solo 401(k) participants could rollover your accounts into an IRA.
Let’s get back to the first part of Brady’s question. He said that he changed his business type from an LLC to a corporation and hired his girlfriend as a non-paid employee. Brady, neither one of those actions makes you unable to have a solo 401(k).
You can have a solo 401(k) no matter your business type. And having an “unpaid employee” isn’t an employee, but a volunteer. And even if you did pay your girlfriend, you could keep your solo 401(k) if she doesn’t work more than 1,000 hours per year or about 20 hours per week. Brady also asked about contribution deadlines, which we’ll get to in a moment.
3. Contribution limits are high
With a solo 401(k), you act as both the employer and the employee in your business. That means you can make both voluntary contributions (on the employee side) and profit-sharing contributions (on the employer side). The combination allows you to save more than with any other type of retirement account.
For 2020, on the employee side of a solo 401(k), you can contribute as much as 100% of your salary, up to $19,500, or $26,000 if you’re over age 50.
For 2020, on the employee side of a solo 401(k), you can contribute as much as 100% of your salary, up to $19,500, or $26,000 if you’re over age 50. As the employer, you can also make profit-sharing contributions in an amount that depends on your business entity type. And both kinds of contributions are always 100% vested, so you never lose them if you leave the company or dissolve it.
If you’re a sole proprietor, general partnership, or have a single-member LLC, you can contribute up to 20% of a participant’s earned income. If you’re incorporated, profit-sharing contributions can be up to 25% of the business entity’s income that’s subject to the self-employment tax.
However, there is a maximum annual contribution limit of $57,000, or $63,500 if you’re over 50. For example, if you’re younger than age 50 and max out your employee salary deferrals at $19,500, the business could contribute an additional $37,500 to your account, for a total of $57,000. If you’re over 50, you could max out at $26,000, and the business could put in the same amount to reach $63,500.
If the owner’s spouse also earns income from the same business, they can make contributions to the same solo 401(k). The spouse’s contribution limit is separate from the owner. In other words, a married couple can double up and contribute up to $114,000 ($57,000 x 2), or $127,000 ($63,500 x 2) if both are over age 50.
But when a couple participates in a solo 401(k), they don’t each have to contribute the same amount or even make contributions. There isn’t a required annual minimum contribution you must make to a solo 401(k) as the employer or employee.
4. There are contribution deadlines
The deadline to contribute to a solo 401(k) depends on your business entity type. If you’re a sole proprietor, general partnership, or single-member LLC, you have until your tax-filing deadline (April 15, or October 15 if an extension is filed) to make employee and employer contributions for the prior year.
But if you’re incorporated or a multi-member LLC, your employer and your employee side solo 401(k) contribution deadlines are different. As an employee, you only have until December 31 to make current year contributions. As the employer, you have more time, until your tax-filing deadline, including any extensions.
The second part of Brady’s question is about the timing of current year contributions. Since he has an S corp, he’ll need to make employee contributions by the end of the year, but he has until his tax-filing deadline to make profit-sharing contributions as the business owner. And the funds must be in the account by that date, so be sure to start the process several weeks earlier.
5. You get excellent tax benefits
Just like with other types of retirement plans, a solo 401(k) gives you terrific tax benefits. As I mentioned, it allows you to stash away more money than any other account because you can contribute as both the employee and the employer.
Every pre-tax dollar you contribute to a traditional solo 401(k) as an employee is tax-deferred until you make withdrawals in the future. It reduces your taxable income for the current year.
Every pre-tax dollar you contribute to a traditional solo 401(k) as an employee is tax-deferred until you make withdrawals in the future. In other words, it reduces your taxable income for the current year. Additionally, your investment growth in the account is also spared from tax until you take distributions after age 59½.
On the employer side, your solo 401(k) contributions and expenses for all participants are generally tax-deductible for your business. Even if you don’t max out the allowable limits, making modest contributions over time can really add up.
For example, let’s say you’re a sole proprietor and will have $60,000 in net self-employment income in 2020. If you save 10% in a solo 401(k), you’ll reduce your taxable income by $6,000.
If you invest this amount for 30 years with a moderate average 8% return, you could easily have $1 million to spend in retirement. Imagine investing even more! With a solo 401(k), you can reduce your taxes and build up a healthy nest egg at the same time.
6. You can choose a Roth version
The solo 401(k) also comes in a Roth, or after-tax version. With a Roth, you must pay tax upfront on contributions, so you don’t receive an immediate benefit in the current tax year. However, future withdrawals of original contributions and investment earnings are 100% tax-free, as long as you’ve had the account open for five years and reach age 59½.
Another huge benefit is that unlike a Roth IRA, which prohibits high earners from contributing, there is no income limit for a Roth solo 401(k).
Another huge benefit is that unlike a Roth IRA, which prohibits high earners from contributing, there is no income limit for a Roth solo 401(k). It comes with the same annual contribution limits as the traditional version.
Note that Roth contributions can only apply to the employee side of a solo 401(k). When you make contributions as an employer, they must be made on a pre-tax basis.
7. Rollovers are allowed
As I mentioned, you can generally roll over funds from a solo 401(k) into other retirement accounts. As long as you move funds into a like account, no tax will be due.
For instance, you could roll over a Roth solo 401(k) to a Roth IRA. Or a traditional IRA to a traditional solo 401(k). That gives you the flexibility to consolidate retirement accounts when needed.
8. Loans may be possible
A solo 401(k) may allow you to take a loan from yourself if you set up this feature in your plan. You can typically borrow up to $50,000, or 50% of your account balance, whichever is less. For example, if your solo 401(k) has a $20,000 balance, you could borrow up to $10,000 from yourself.
You can use the funds for any purpose you like with a maximum payback period of five years. In some cases, you can include a feature allowing a longer payback (such as 15 years) for money used to buy a primary home. However, you must repay a loan with the interest rate spelled out in your plan, such as the prime rate plus 1%.
Any amounts not paid back on time will be treated as an early distribution, which is subject to income tax, plus an additional 10% penalty if you’re younger than age 59½.
9. Solo 401(K) maintenance is low
Having a solo 401(k) is relatively simple to manage and inexpensive compared to a regular 401(k). You don’t need to file tax documents until your plan balance grows significantly. When you have more than $250,000 at the end of a tax year, you must submit Form 5500-EZopens PDF file .
Having a solo 401(k) is relatively simple to manage and inexpensive compared to a regular 401(k).
The cost to set up and administer a solo 401(k) varies depending on the investment firm you use and the total assets in the plan. There may be an initial fee of $100 and monthly fees of $20 when you’re just getting started. Establishing a plan can take less than 30 minutes.
10. There are plenty of investment choices
You can put solo 401(k) contributions in a variety of investments. What’s available depends on the firm you choose, such as a bank or brokerage. But it typically includes a menu of mutual funds or exchange-traded funds (ETFs), at a minimum.
Since a solo 401(k) offers high contributions limits, it’s perfect when you have high self-employment income and no full-time employees. The only downside is that if you do plan to hire employees, you’ll have to make some changes down the road. The need to be flexible about your solo 401(k) in the future is still well worth the benefits you receive.
About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
