Solo 401ks – also known as individual 401ks – have some pretty serious benefits if you’re self-employed and want to start saving for retirement. Like any other kind of retirement savings plan, there are solo 401k rules about contribution limits, covering your spouse, tax advantages, etc.
Let’s get straight to the facts and cover the rules about how solo 401ks work and get answers to all of your burning questions about solo 401ks.
Solo 401k rules & answers to frequently asked questions
Who is eligible for a solo 401k?
Let’s start with one of the most basic solo 401k rules: eligibility. You are eligible for a solo 401k if you are self-employed and do not have any employees. This applies to self-employed small business owners, freelancers, 1099 contractors, and solopreneurs.
The most important qualification is that you do not have any employees. However, solo 401ks are unique in that you can cover your spouse if they are drawing income from your business. Your spouse is the only employee that could potentially qualify under your solo 401k plan.
Solo 401k contribution limits
Many people choose a solo 401k because it potentially has the highest contribution limit of any self-employed retirement plan. The contribution limit is up to $57,000 in 2020, and you can contribute up to $58,000 in 2021. There’s an additional catch-up contribution of $6,500 for those 50 or older.
You can make contributions to your solo 401k as both the employee and employer. You play both roles because you’re self-employed. Here’s how it works:
- Employer: You can make profit-sharing contributions of up to 25% of your self-employment income. This amount is your business net profit minus half of your self-employment tax and the employer plan contributions you make for yourself (and your spouse if applicable). The limit on compensation for 202 is $285,000 and it’s $290,000 for 2021.
- Employee: You can contribute up to $19,500 in 2020 and 2021, or 100% of your compensation for the year, whichever is less. The catch-up contribution for those 50 and older applies here. So as the employee, you have the potential to contribute $26,000 to your solo 401k.
Rules for figuring out your solo 401k contribution
Figuring out how much you can contribute to your solo 401k as the employee is easy. It’s the lesser 100% of your contribution or up to $19,500.
Employer contributions can be a little more difficult to figure out. Here’s the rule on employer contributions: you can make profit-sharing contributions of up to 25% of your net income from self-employment.
Your net earnings are your net business profit less half of your self-employment tax and employer plan contributions you make for yourself and your spouse. You can find your net income on your tax forms. It’s on your tax Schedule C or C-EZ if you are a sole proprietor, and it’s your w-2 wage if you’re an S-Corp.
Solo 401k contribution deadlines
The contribution deadline is based on your tax filing date, and that’s for both employee and employer contributions. Tax filing deadlines change based on the kind of business you run. Here are some important dates:
- The deadline for a sole proprietorship is April 15
- The deadline for an S-Corp is March 15
You must establish your solo 401k by December 31 to make contributions for that year, and your contribution deadline is then technically the tax filing deadline of the following year.
Using 2020 for example, you must establish your solo 401k by December 31, 2020, and then you can make contributions for 2020 until April 15, 2021, if you’re a sole proprietor.
Taxes on a solo 401k
The rules with a solo 401k let you choose your tax advantage. You can do a traditional or Roth solo 401k. Traditional contributions are tax-deferred and reduce your taxable income for the year. But you will owe taxes when you take distributions in retirement. Roth contributions are taxed as income and grow tax-free into retirement.
Most people choose traditional contributions if they believe they are making a lot more now than they will in retirement. You’ll be at a lower tax rate, so you won’t pay as much in taxes. A Roth solo 401k is better if you think you’ll be earning about the same or more than in retirement because you’ve already paid taxes on that money.
Solo 401k spouse rules
You can cover your spouse under your solo 401k if they are drawing income from your business. Your spouse is the only exception to the no employees solo 401k rule.
For your spouse to be eligible, they must be a part-time employee, full-time employee, or co-owner of your business. You can effectively double the contributions if both you and your spouse contribute up to the maximum amount, assuming you’ve earned enough to cover those contributions.
Rules about withdrawing funds or taking loans from a solo 401k
You can start taking disbursements from your solo 401k at age 59 ½ without any early withdrawal penalties. The penalty for early withdrawals is generally 10% of the withdrawal amount. There are few exceptions, but the IRS may waive the penalty in circumstances like:
- Medical expenses that exceed 10% of your adjusted gross income
- Permanent disability
- Certain military service
- A Qualified Domestic Retirement Order (QDRO) issued as part of a divorce or court-approved separation
After you turn 59½ there are no penalties, and you must take your first distribution by April 1 of the year after you turn 72.
A 401k loan is when you borrow money from your retirement savings, and you’ll have to have a provision in your plan that allows for loans. You are typically limited to the lesser of 50% of the balance of your solo 401k or $50,000. Technically, you can take out more than one loan on your solo 401k, but the amount cannot exceed $50,000 or 50% of your vested balance.
Solo 401k loans must be repaid in 5 years or they’ll be taxed as an early withdrawal at a rate of 10%. Interest on your solo 401k loan is not deductible, plus you’re also not earning interest on that loan amount because it’s not invested.
The government did double the loan amount from $50,000 to $100,000 under the CARES Act to help those affected by the pandemic, but it went back to the normal amount on December 31, 2020.
How to open a solo 401k
The first step is to decide which solo 401k provider you want to use. Most of the major brokerages have them, like Fidelity, Charles Schwab, Vanguard, etc.
You need your Employer Identification Number (EIN) or your Social Security number, and you’ll need that when you start preparing your documents. That includes a plan adoption agreement, which you’ll get from your solo 401k provider.
You need to set up the plan by December 31 of this year if you want to make contributions to it, and then you’ll have until your tax filing deadline for that year to make contributions. That’s typically April 15 of the following calendar year.
You can choose who to invest what’s in your solo 401k. I highly recommend deciding on a provider with lots of different investment options, like mutual funds, bonds, ETFs, index funds, stocks, etc. More choices gives you more control. You can self-direct your investments or use your providers’ robo-advisor if they have one. ‘
Once your solo 401k hits $250,000 or more in assets at the end of a given year, the IRS will require you to file a Form 5500-SF.
The final word about solo 401k rules
A solo 401k can be a really good want to save for retirement if you’re self-employed. Many of the rules are major perks overall – higher than average contribution limits, getting to choose your tax-advantage, and being able to cover your spouse.
If you’re trying to figure out the rules, don’t let them keep you from opening your retirement account. There’s never been a better time to start saving for the future.
Contributions to your solo 401k are tax-deductible if you make traditional contributions. You pay taxes on your disbursements in retirement. The alternative is making Roth contributions, which are made with after-tax money. You pay taxes on that money now but not on your disbursements.
No, matching contributions apply to full-time employer 401k plans. A match is when the employer matches what the employee has contributed to their 401k. With a solo 401k, you make contributions to your solo 401k as an employee and profit-sharing employer contributions, and these are not based on whether or not an employee contribution has been made.
Yes, you can have more than one 401k. It’s something you might consider if you have a side hustle in addition to your full-time job. The thing you need to understand about having multiple 401ks is that the maximum employee contribution applies across all accounts.
A solo 401k is a tax-advantaged retirement savings account for self-employed people who don’t have any employees. The one exception is if your spouse draws income from your business as either a part-time or full-time employee.
You make contributions to your solo 401k as both employee and employer, and contributions can be traditional or Roth, which lets you choose your tax advantage.