The Many Advantages of a Solo 401(k)

  • Many freelancers would benefit from saving into a new kind of 401(k) just for them.

  • Unlike corporate plans, these are easy and cheap to administer.

  • Contribution limits are much higher than other small business plans of the past.

Many Americans rely on their employer-sponsored 401(k) plans to save for retirement. But what about all those individuals who are their own boss?

Although not well-known, there is a novel retirement savings plan — the “solo 401(k)” — available to self-employed workers with no other employees in the business, except for a spouse.

The plan works by allowing freelancers to wear the hat of an employer and employee, simultaneously.

Because of its hybrid employer/employee structure, a solo 401(k) gives self-employed individuals the ability to set aside large sums for their retirement and reap the rewards of reduced income taxes as well as tax-deferred compounding of the funds invested.

The plan also eliminates many of the cumbersome and complex rules governing corporate 401(k) plans while providing those who are self-employed many of the same retirement savings benefits of workers who participate in an employer-sponsored plan.

Substantial contributions

Because of the unusual provision that allows self-employed workers to make contributions as employer and employee, one of the most advantageous provisions of the solo 401(k) is the substantial amount of tax-deductible contributions available for the self-employed.

For instance, the maximum contribution amount in a solo 401(k) for 2019 is $56,000.

That counts up to $19,000 in pre-tax individual income. The balance comes from the employer contribution. As a solo 401(k) owner you can contribute to both sides of the plan.

That amount can be up to 25% or your net self-employment income or compensation. That’s considered profit-sharing. The maximum contribution for those age 50 or over is $62,000.

Other qualified retirement plans for those who are self-employed, such as a SEP IRA or SIMPLE, cannot match the generous contribution amounts allowable under the solo 401(k).

SIMPLE plans allow only $13,000 for 2019, $6,000 for those 50 or older, and an employer match of 3% of compensation up to a maximum of $5,600. For 2019, SEP employer contributions are limited or 25% of income; there is no employer contribution.

Tax treatment

Self-employed business owners can establish the solo 401(k) as a traditional retirement plan where all contributions are tax deductible. Any investment gains accrue on a tax-deferred basis. Upon retirement, distributions are taxed at the individual’s current income tax bracket.

These provisions related to income tax liability are similar to those governing traditional IRA accounts.

A second option allows a business owner to establish the solo 401(k) as a Roth 401(k). Contributions are made with after-tax dollars, investment gains accrue on a tax-free basis and upon retirement, and withdrawals are entirely tax-free.

The tax treatment of contributions for this solo 401(k) option is the same as a traditional Roth. However, a traditional Roth IRA is limited to those whose income falls below certain threshold levels.

Any self-employed individual who opens a solo 401 (k) and select the Roth option, regardless of their income level.

Additional benefits

The solo 401(k) offers additional benefits not available in other self-employed retirement plans. For instance, business owners can borrow against the assets in their plan, penalty and tax-free.

This unique provision can be extremely useful for self-employed individuals, whose business may need a temporary infusion of cash to sustain operations. IRS regulations do not allow tax-free loans for other qualified retirement savings plans.

There are several important rules governing solo 401(k) plans.

First, the account must be opened by the end of the calendar year in which contributions are going to be deducted from the business owner’s taxes. Funds can be put into the account as late as the tax filing date the following year.

Secondly, individuals need to be mindful of transfers from one provider to another. An individual can make a transfer of assets from one investment account to another as long as the assets move directly into the new investment account.

If the assets go to the individual first and then subsequently to the new investment provider, there can be tax consequences for the indirect transfer.

Thirdly, be aware that if a business owner hires just one individual, excepting a spouse, solo 401(k) plans may be subject to the strict non-discriminatory provisions pursuant to the Employee Retirement Income Security Act (ERISA).

This provision was enacted to ensure that a business owner’s retirement plan is not significantly more favorable than that of the businesses employees.

Before setting up the account, individuals should conduct some due diligence in terms of which investment firms would be the most appropriate custodians for the solo 401(k) account. The fee structure among investment brokerage firms can vary widely.

Some firms offer a no-fee account and the individual is charged only when they purchase securities in their investment account.