A solo 401k plan is an excellent option for one-person business operators, freelancers, and contractors. Unlike an IRA, no particular custodian is required, and contributions can be made from any income. A solo 401(k) offers all the benefits of an employer-sponsored retirement account, including tax breaks, investment options, and loans. It’s also flexible and easy to use.
A single person 401k plan (also known as an individual 401(k) or a one-participant 401(k)) is a retirement savings option for self-employed workers and small business owners. Like traditional 401(k) plans, solo 401(k)s typically offer tax perks, including tax-deferred or tax-free growth and a generous annual maximum contribution limit. In addition, contributions to a solo 401(k) are fully tax deductible up to IRS limits, which can benefit self-employed individuals and side hustlers who need to minimize their taxable income. “This is a major advantage over alternatives such as the SEP IRA, SIMPLE IRA, traditional and Roth IRA,” Conroy says. Conventional wisdom holds that the former is better if you can contribute more to a solo 401(k) than to a Simplified Employee Pension IRA (SEP IRA). That’s because SEP IRA contributions cannot exceed 25% of compensation for an individual. In addition, solo 401(k)s allow you to invest in more asset classes than SEP IRAs, which only let you put money into traditional stocks and bonds. However, you’ll need to understand prohibited transaction rules and other limitations of investing in alternative assets through your 401(k) because they can result in tax penalties if you break the rules. Fortunately, many brokers offer robo-advisors, online tools, and in-person consultations to help you manage your investment options.
Whether you’re running your own business or freelancing, getting the tax breaks from traditional workplace retirement plans can be challenging. However, self-employed people have some solid options to save for retirement: SEP IRAs, SIMPLE IRAs, and solo 401(k)s. A solo 401(k) is an individual retirement account that can hold many of the same investments as a traditional IRA but with higher contribution limits. The plan also allows you to invest in a broader range of assets, including alternative ones such as cryptocurrencies and metals. To qualify for a solo 401(k), you must be self-employed or a sole proprietor and not have any full-time employees. The plan must also be a “qualified” plan under the IRS rules. A solo 401(k) offers significant tax advantages over a traditional IRA or SEP IRA, depending on how much you earn and your situation. For example, in 2023, a worker earning $100,000 in net profit could contribute up to $41,087: $22,500 in salary deferrals and $18,587 in a profit-sharing contribution as an employer. That’s more than double what the same worker could put into a SEP or a regular IRA. (The limit is even higher for workers age 50 and over). Those are some significant savings.
The benefit of an individual 401(k), sometimes called a solo 401(k) or a self-directed 401(k), over a traditional or Roth SEP IRA is most apparent when a sole proprietor has net earnings over $54,000. At that point, the 401(k) offers more flexibility for contributions than an SEP IRA. A solo 401(k) allows you to make both employee (elective deferrals) and employer (profit-sharing) contributions. And, like a workplace 401(k), it typically comes with a Roth option, too. As an entrepreneur, you can contribute up to 100% of your net adjusted self-employed income as an employee and up to 25% of your net adjusted self-employed income as a profit-sharing contribution. You can also make catch-up contributions if you are 50 or older. Advisors who work with business owners often advise them to opt for a solo 401(k) when they can afford to because the plan’s flexibility can be a big plus. For instance, an entrepreneur can use the plan to invest in alternative assets, such as real estate, crypto assets, or precious metals, typically prohibited in SEP IRAs.
A solo 401(k) is one of many options for self-employed workers to save for retirement. Individuals who generate net business profits can also use Simplified Employee Pension (SEP) IRA accounts, which are tailored for small businesses and allow contributions from the employer and the worker. Then there are traditional and Roth IRAs, which offer similar tax breaks but have lower contribution limits than the SEP IRA. But a solo 401(k) can be better than these alternatives if the account owner aims to maximize contributions and get the best possible tax break. That’s because, with a solo 401(k), you can wear two hats and contribute as both the employee and the employer up to certain limits. For instance, say you earn $180,000 in net self-employment income this year and want to maximize your retirement plan contributions. In a solo 401(k), you could contribute up to $54,000—or the entire $180,000 in elective deferrals plus a $27,000 profit-sharing contribution as an employer. You can invest in any eligible fund in a solo 401(k) account. Still, the IRS prohibits you from investing in specific property or securities considered “disqualified persons.” These include an entrepreneur’s own C corporation, limited liability company (LLC), and partnerships. Understanding these rules is essential before investing in a solo 401(k). A financial planner can help you make sure you follow the rules.