Understanding the Solo 401k for the self-employed

401k blog 2

Image credit: Photo by Visual Stories || Micheile on Unsplash

The Solo 401k, the Individual(k), the Self-Employed 401(k)…several different names for the same concept: a retirement savings option for the small business owner (and their spouse). Until about 20 years ago, the self-employed got the short end of the stick when it came to 401(k) plans. Which makes sense, as a traditional 401k plan involves matching retirement contributions from your employer. And, if you’re self-employed…you get the gist.

If you’re a small business owner with no employees, you’re going to want to consider the Solo 401(k) for your retirement savings plan. You will be glad to know your retirement potential is almost unlimited as you’ll see below, and less restricted than virtually all company-sponsored 401(k)s.

The ins and outs of the Solo 401(k)

Whether you’re a sole proprietor, independent contractor or even own a limited liability company (LLC), you are eligible for a Solo 401(k). There are no income or age restrictions, but you must be a small business owner with no employees, other than your spouse.

Like traditional 401(k) accounts, there are yearly contribution limits, however, these are astronomically high when compared to 401k limits (around $19,500 in 2020). For example, in 2020, the limit was $57,000, and in 2021 $58,000. If you are 50 or older, there is also a special yearly ‘catch-up contribution’ of $6,500.

Now, here’s where you need to pay attention: you can contribute to your Solo 401(k) as both an employee and an employer because, well, that’s technically what you are. However, your deductible contribution as the “employer” (you) can’t exceed 25% of the “employee’s” (you) contribution. As an employee, you can contribute up to 100% of your salary, but no more than the annual limit of $19,500, with an additional $6,500 for those 50 and above (in 2021). Your contribution as both employer and employee can not exceed the limit of $58,000.

A note on the Small Business 401(k)

Now, the Solo 401(k) shouldn’t be confused with the Small Business 401(k). If you own a small business with employees other than yourself and your spouse, you can open a different type of retirement savings account called the Small Business 401(k). The rules and regulations are almost identical to the Solo 401(k).

As the employer, you can make deductible contributions of up to 25% of the employee’s salary for each qualified employee (there was a salary limit of $285,000 here, which is subject to change annually). Similar to a Solo 401(k), the employee and employer contributions cannot exceed $58,000, plus the additional $6,500 catch-up contribution for those 50 and up.

What about taxes?

You’re probably wondering what the tax implications are in all of this. For both Solo 401(k) and Small Business 401(k) accounts, pre-tax salary contributions aren’t subject to federal income tax until the money is withdrawn. Post-tax (or, Roth contributions) can be withdrawn federal income tax-free five years after the first day of the year of your first Roth contribution. You must be at least 59 and a half years old as well. If you do decide to withdraw your Roth 401(k) before you reach 59 and a half, you could be subject to an additional 10% federal income tax.

Thanks to Solo 401(k)s and the Small Business 401(k)s, sole proprietors and small business owners now have the option of helping their employees (and themselves) prepare for retirement.

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