A Raleigh, NC Financial Advisor Explains Solo 401(k)
When you first open your small business, you may not be thinking about wealth management, estate planning or even consulting with a financial advisor about tax smart investment management. After all, when you work for a big company, you normally get access to employer-sponsored retirement plans like a 401(k) to help meet your long term financial goals.
Turns out, one of the perks of self-employment is your company can provide a solo 401(k), or what the IRS calls a one-participant 401(k). Designed for self-employed workers, a solo 401(k) mimics many of the features of an employer-sponsored plan, without the drag of working for the man.
What is a Solo 401(k) Plan?
Simply put, a Solo 401(k) is a retirement account designed for the self-employed, or business owners with no full-time employees. A Solo or Individual 401(k) plan offers many of the same benefits of a traditional 401(k) with a few distinct differences. A traditional 401(k) is offered by a company allowing employees to save for retirement by contributing to their own accounts directly from their pay. Sometimes the company also contributes to each employee's account.
With an Individual 401(k) business owners can make contributions both as an employee and as an employer, helping maximize retirement contributions and business deductions. Also, spouses who derive income from the business can make contributions to their account as well. Plus, if the business owner's spouse makes contributions as the employer, the non-owner spouse would also get a contribution from the business at the same percentage.
Additionally, small businesses with multiple business owners can also use the plan, just remember that the business sets up one plan with all the owners as participants, thus all owners follow one set of rules.
What is a Roth Solo 401(k)?
Back in 2006, Congress put into law the Roth 401(k). This gave 401(k) plans the same benefits of the already-established Roth IRA.
Five years prior, the Economic Growth and Tax Relief Reconciliation Act of 2001 made it so self-employed individuals could start their own 401(k) plan. This became popularly known as the Solo 401(k) or Individual 401(k) retirement plan. Merge the two together to get the Roth Solo 401(k).
The Roth Solo 401k is a good option for self-employed and small business owners. With the potential increase of federal and state income tax rates, the ability to generate tax-free returns from your IRA investments is the last surviving legal tax shelter.
With this plan, you can make almost any type of investment tax-free. This includes real estate, precious metals and more. You can also continue to make traditional investments, like stocks, bonds and mutual funds. When you reach age 59 1/2, you’ll have the ability to live off your Roth 401(k) assets without having to pay tax.
Look at the Roth Solo 401k this way: if you start contributions in your 40s and generate a modest rate of return, you may have over $1 million tax-free when you retire.
Solo 401(k) Contribution Limits
The plan allows one-person businesses to establish a 401(k) with a participating brokerage and save up to $20,500 annually (in 2022) as elective deferrals, in the same way that participants in a regular 401(k) plan can deduct money from their paychecks.
The solo 401(k) also accepts employer matching contributions to the plan. Since the employee is also the business owner, he or she determines how much to match. The business can contribute 25 percent of its profits to the solo 401(k), up to a maximum of $61,000 in 2022.
Business profit-sharing contributions are based on your net profits minus half of your self-employment tax and the plan contributions you made for yourself (and any participating spouses). The limit on compensation used to factor in your annual contribution is $305,000 for 2022.
Keep in mind that the IRS limit on solo 401(k) contributions considers both employee and employer contributions per individual.
People aged 50 and older may contribute an additional $6,500 in 2022 as a catch-up contribution, in line with bonus contributions allowed in other 401(k) plans. That means the total combined employee and employer contributions may not exceed $67,500 for 2022.
Solo 401(k) Pros
The solo 401(k) can be an excellent choice for those with a side gig as well, especially if they’re already able to live comfortably on their main salary. With the solo 401(k) you can go above the usual limits of a 401(k).
While you may contribute to multiple 401(k) accounts, your total employee contribution to all types of 401(k)s may not exceed the annual maximum contribution, that is, $20,500 in 2022.
But the solo 401(k) can be valuable even if you already have a 401(k) plan and even if you’ve maxed out that other plan for a given year. That’s because you can still make an employer contribution, allowing you to exceed the smaller employee-only contribution amount. So, the solo 401(k) allows you to save more with the employer contribution, reducing your business taxes.
Another benefit of the solo 401(k) is that it doesn’t prevent you from taking advantage of other retirement plans such as the IRA. You can still contribute up to the annual maximum there. If you’re an individual looking to set up a traditional IRA or Roth IRA, then you’ll want to look at the benefits of those plans.
Like the typical 401(k) plan, the solo 401(k) also allows you to take out a loan against your account.
Solo 401(k) Cons
The solo 401(k) has the same drawbacks of typical 401(k) plans, plus a couple others that are specific to itself. Like other 401(k) plans, the solo 401(k) will hit you with taxes and penalties if you withdraw the money before retirement age, currently set at 59½. Yes, you can take out a loan or may be able to access a hardship withdrawal, if needed, but those are last resorts.
In addition, it can take more paperwork to open a solo 401(k), but it’s not especially onerous. You usually won’t be able to open the account completely online in 15 minutes, as you would a typical brokerage account. Plus, you’ll need to get a tax ID from the IRS, which you can do online quickly. On top of this, you’ll have to manage the plan, choose investments and ensure that you don’t exceed annual contribution limits.
Another wrinkle: Once you exceed $250,000 in assets in the plan at the end of the year, you’ll need to start filing a special form with the IRS each year.
Bottom line
The solo 401(k) is a good option for the self-employed to save money for retirement and if your spouse is involved in your business, you can really take maximum advantage of the program. However, it can be useful even for smaller businesses because of the ability to save so much so quickly, and its complete flexibility makes it a great option for the self-employed.
For more financial advice on retirement plans for small business owners please check out this podcast we created on all the different retirement savings plans available to sole proprietor companies.
https://www.nerdwallet.com/article/investing/what-is-a-solo-401k
https://www.irafinancialgroup.com/learn-more/solo-401k/the-roth-solo-401k-secret/
https://www.trustetc.com/self-directed-accounts/small-business/roth-solo-401k/
https://www.investopedia.com/best-solo-401k-companies-5089155
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation. Neither Olde Raleigh Financial Group nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information. Investing involves risk, including the loss of principal.
