What is a Solo 401(k) Plan?
A solo 401(k) plan is designed for business owners and couples running a business together with no employees. The plan also covers business partners. Moreover, you can also plan your retirement savings with this account, even if you are a full-time freelancer or an individual with a side hustle.
Solo 401(k) Eligibility Rules
Take a look at the eligibility requirements for investing in a solo 401(k) retirement plan:
- The business you run must produce an income verified with your tax records.
- A part of the income that goes into the account must come from your own business. Moreover, you need to run the business on your own or with your spouse or partners.
- Every freelancer, small business owner with no employee (except their spouse), sole proprietor, and independent contractor is eligible for this retirement plan.
Solo 401(k) Contribution Limits 2023
Since the solo 401(k) plan requires you to have no other employees than yourself and your spouse, you can contribute as an employer as well as an employee.
Depending on your contribution role, the IRS has set certain contribution limits for Solo 401(k) that change yearly.
- Solo 401(k) Contribution Limits 2023 as an Employee: In 2023, as an employee, you can contribute up to $22,500 or 100% of compensation to your plan. If you are 50 or older, you can contribute an additional $7,500.
- Solo 401(k) Contribution Limits 2023 as an Employer: You can contribute additional profit sharing of up to 20% or 25% of your net self-employment income or compensation as an employer depending upon how your business is established. The limit on compensation is $330,000 in 2023.
Types of Solo 401(k) Plans
The solo 401(k) plan has two types: Traditional 401(k) and Roth 401(k). With each plan, you get different tax advantages.
- Traditional Solo 401(k) Plan: When you make contributions to this plan, you reduce your taxable income and tax bill. You invest in pre-tax dollars where you can claim an immediate tax break for your contribution. You pay taxes on your initial contributions and the money earned on investments at your retirement age when you start to take distributions. The traditional solo 401(k) plan is ideal for people with a lower tax bracket post-retirement. If you have a higher tax bracket post-retirement, you might end up with a heavy tax amount.
- Roth Solo 401(k) Plan: There are no income limits for people investing in the Roth solo 401(k) plan. In this plan, contributions from income are already taxed. Withdrawals made after 59 ½ are void of taxes, at least post five years of making contributions. Penalties are imposed for withdrawing before the age of 59 ½. You can pull out contributions tax and penalty-free, but you cannot do the same with your investment earnings until you have reached the 5 year and 59 ½ plateaus.
Which Solo 401(k) Plan Should You Choose?
The choice comes down to whether you will fall under a higher tax bracket after retirement than you are facing today. If you are paying lower taxes now, a Roth solo 401(k) plan might be your choice. If you anticipate a lower tax bracket after retirement than now, a traditional solo 401(k) is better.
Any employer profit share contribution cannot be Roth. However the next day you can do an internal Roth conversion and pay the income tax the following year on the converted amount. cannot save the employer contribution into your Roth solo account. Financial advisors make their bets on mixing pre-tax and after-tax retirement accounts.
However, selecting the perfect solo 401(k) plan is solely based on your choice, age, income, and location.
Solo 401(k) Withdrawals
Money withdrawal is based on the type of solo account you have. Here are possible taxes or penalties you can face on a solo 401(k) withdrawal.
Solo 401(k) Early Withdrawal
Depending on your solo account, withdrawal rules apply.
For an early withdrawal (before 59 ½) on a traditional solo 401(k) account, you have to pay a 10% penalty plus the additional taxes. Contribution withdrawals are tax and penalty-free with a Roth solo 401(k). But a penalty and income tax are applied to earnings.
Although there are repercussions of early withdrawals, some exceptions are reserved. They include:
- Permanent disability
- Qualified Domestic Retirement Order (QDRO) issued by court-approved separation
- Military service
- Medical expenses exceeding 10% of gross income
Solo 401(k) Withdrawal in Retirement
Withdrawing money from you solo 401(k) account after 59 ½ leads to no penalties. Income taxes are imposed on post-retirement withdrawals based on the type of solo 401(k) account you have.
Roth solo 401(k) withdrawals post-retirement are tax-free if made after five years of the first contribution. With a traditional solo 401(k), you pay income tax upon withdrawals.
Is Solo 401(k) Tax Deductible?
If you pick traditional solo 401(k), your contributions reduce income every year. Hence, the distribution in retirement is taxed as ordinary income.
With a Roth solo 401(k) plan, there are no initial tax breaks. So, you get tax-free distributions post-retirement.
How to Open Solo 401(k)?
- Firstly, you need to choose a broker to provide you with a plan adoption agreement and account application.
- You get an Employer Identification Number (EIN) from the IRS. This is a tax ID for employers.
- Once you fill necessary documentation and get your EIN, start funding your retirement account from another retirement account or a savings account.
- After funding your account, determine your pathway to invest your money.
SEP IRA vs Solo 401(k)
For business owners with no employees, there are two best options to choose from – a solo 401(k) and a Simplified Employee Pension IRA (SEP IRA). Both have their own tax benefits. However, solo 401(k) might be a better fit for the following reasons:
- More Savings with Solo 401(k) and Borrowing Potential– Your total contributions cannot exceed 25% of your net adjusted income with a SEP IRA, which means your total can be up to $66,000 in 2023. In comparison, you save more with a solo 401(k). Moreover, with a 401(k) plan, you can contribute as both employee and employer. A SEP Ira follows IRA rules and you cannot personally take out a loan. The Solo 401 k allows for personal loans up to 50% or $50,000 for any reason at any time.
- You Get a Roth solo 401(k) Option– If tax-free withdrawals are your choice, Roth solo 401(k) is preferable. SEP IRA only has a pre-tax contribution option with no availability of a Roth account.
- Give Catch Up Contributions for Savers Above 50– Below 50 years of individuals can contribute a maximum of $66,000 in 2023 to their solo 401(k) or SEP IRA. But individuals above 50 can make catch-up contributions of up to $7,500 as an employee with solo 401(k). While SEP IRA only funds employer contributions. No catch-up contributions are allowed.