What is a Solo 401k? Is It the Best Self-Employed Retirement Option?

What is a solo 401k? Is it the right choice for my retirement savings? These are the kinds of things you have to think about if you’re self-employed.

Being self-employed has some major perks. You get to set your own schedule and be your own boss – it’s pretty great. But one issue self-employed people face is how to handle their retirement savings.

Fortunately there are options, including a solo 401k, which is designed specifically for business owners who do not have any employees: aka solopreneurs, freelancers, and any other kind of self-employed person who works as a solo worker. Hence the name solo 401k.

This article is going to take a deep dive into how a solo 401k works, including contribution limits and deadline. You’re also going to learn about the best solo 401k providers, and I’ll answer frequently asked questions about them.

What Is a Solo 401K?

A solo 401k is an individual retirement plan created for business owners who do not have any employees. The lack of employees is a key distinction between a solo 401k and other self-employed retirement plans like a SEP IRA and SIMPLE IRA.

If you’re trying to differentiate a solo 401k from other plans, remember that solo = individual.

The IRS is very clear about not having any employees if you want to set up a solo 401k. However, the IRS does allow you to cover your spouse with your solo 401k if your spouse draws income from your business.

The advantage of covering your spouse is a major perk for self-employed people, but another advantage is that you can make both traditional and Roth contributions. Traditional means tax-deferred, and your distributions are taxed in retirement. Roth contributions are made with after-tax dollars, so your retirement distributions are tax-free.

The benefit of having those options is that you can decide which makes sense for you. Roth makes sense if you expect to be in a higher tax bracket when you’re retired. Traditional contributions are best for people who believe their tax rate will be lower in the future.

Solo 401K Contribution Limits

To understand the contribution limits, you need to remember that as a self-employed person, you are both employee and employer.

The total solo 401k contribution limit for 2021 is $57,000 in 2020 and $58,000 in 2021 with an additional $6,500 catch-up contribution if you are 50 or older.

Within that total contribution limit, there are limits for each of your roles

• Employee: As the employee, you can contribute the lesser of 100% of your compensation or up to $19,500 in 2020 and 2021. If you’re 50 or older, you can contribute an additional $6,500 as an employee.
• Employer: In the employer role, you can contribute an additional profit-sharing contribution of up to 25% of what you’re compensated for (this is your net self-employment income) up to the total contribution limit of $57,000 for 2020 and $58,000 for 2021.

When you calculate your contribution percentage as the employer, the max amount of compensation you can use for 2020 is $285,000 and it’s $290,000 for 2020. Like other retirement plans, you can expect solo 401k contribution limits to make regular cost-of-living adjustments.

To help you understand how the contribution limits work, let me give you an example.

You’re a blogger who earned $85,000 from your blog in 2020. As the employee, you contribute $19,500 which is the max employee contribution.

Then as the employer, you contribute an additional $21,250. That amount is figured as 25% of your total compensation. $85,000 x 25% = $21,250

Your total solo 401k contribution for 2020 is $19,500 + $21,250 = $40,750. If you were 50 or older, you can make an additional contribution of $6,500 as a catch-up contribution, for a total of $47,250.

The last thing you need to understand about your solo 401k contributions is that if you’re also employed and participating in your company’s 401k plan, the contribution limits apply across all retirement plans. Your contributions to your solo 401K and company 401k cannot exceed the total limit for the year.

Can Your Spouse Use Your Solo 401K?

Yes, your spouse can be covered by your solo 401k, and this is one of the major benefits of a solo 401k. Your spouse will have to draw income from your business for them to be eligible, but it means the two of you can potentially double your annual retirement savings.

As an employee, your spouse can make up to the $19,500 employee contribution limit. Then as the employer, you can make an additional profit-sharing contribution for your spouse, which again is 25% of compensation.

Your spouse is the only kind of employee that is eligible to use your solo 401k.

What Are the Potential Tax Benefits of a Solo 401K?

Unlike the SEP IRA, you can pick your tax advantage with a solo 401k, either traditional or Roth contributions.

Traditional contributions are tax-deferred. They’re tax-deductible, so they reduce your income in the year they are made. Then, distributions are taxed in retirement as ordinary income. Generally, traditional contributions are best if you think your income will go down in retirement.

Roth contributions are made with after-tax dollars. You pay taxes on your contributions when you make them, so there’s no initial tax break. But then when you take distributions in retirement, they are tax-free. Roth is a better option if you expect your income to increase in retirement.

Related: How to Handle Taxes for Your Side Hustle

Who Qualifies for a Solo 401K Plan?

There are two main eligibility requirements: one is that you must be self-employed, and the second is that you must earn self-employment income.

You can typically fit the first requirement if you’re a freelancer, sole-proprietor, business owner without any employees (although your spouse can contribute if they work for your business), or independent contractor. The second requirement, self-employment income, can be verified through tax records.

How To Set up a Solo 401K

The IRS has specific steps for setting up a solo 401k. But first, you’ll want to decide where you’ll set up your account. Most brokerages have a solo 401k option, like Vanguard, Fidelity, Schwab, etc.

You will need your Employer Identification Number (EIN), and then you’ll start preparing your plan documents. Your solo 401k provider will give you a plan adoption agreement and an application.

After you’ve filled out the paperwork, you can set up contributions, and your plan needs to be set up by December 31 to make contributions for that calendar year. However, you can usually make employer contributions until your tax-filing deadline for the year. That’s often April 15 of the following year. That means for 2020, you can make profit-sharing contributions until April 15, 2021.

You can invest in many of the investments offered by your provider– ETFs, index funds, mutual funds, or individual stocks and bonds. You can self-direct your solo 401k investments, but if your provider offers a robo-advisor, you can use that.

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.

​Read more in 5 Best Solo 401k Companies – Compare the Top Providers.

What Is a Solo 401K? The Final Word

Up until 2002, SEP IRAs were seen as one of the best retirement options for self-employed people. But then the Economic Growth And Tax Reconciliation Act (EGTRRA) enhanced solo 401ks making them a much better option if you’re self-employed and don’t have any employees.

It’s taken a few years for those changes to catch up with everyone– I actually started a SEP IRA shortly after I started blogging full time, but I’m about to switch to a solo 401k.

The changes means self-employed people can take advantage of some serious retirement planning benefits: a higher contribution limit, your spouse can be covered, you can make catch-up contributions, and it allows both Roth and traditional contributions.

Being self-employed and having a good retirement savings vehicle makes self-employment even better because you’re not as stressed about how you’ll handle retirement.