8 reasons to open a solo 401k plan
Updated for 2024
What is a solo 401k plan?
The solo 401k plan is a powerful tool for entrepreneurs to save money for retirement and reduce their current tax bill. These plans are often ignored and overshadowed by the more popular corporate 401k and SEP IRA plans. In fact, there is a lack of widely available public information about them. Simply put, not many people know about it. In this article, I will discuss 8 reasons why entrepreneurs should open a solo 401k plan.
Solo or one participant 401k plans are available to solo entrepreneurs who do not have any personnel on staff. If a business owner employs seasonal workers who register less than 1,000 hours a year, then he or she may be eligible for the solo 401k plans as well. The solo plans have most of the characteristics of the traditional 401k plan without any of the restrictions.
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What are some of the most significant benefits of the self-employed 401k?
Maximize your retirement savings with a solo 401k
Self-employed 401k allows a business owner to save up to $69,000 a year for retirement, plus an additional $7,500 if age 50 and over. How does the math work exactly?
A solo entrepreneur plays a dual role in their business—an employee and an employer. As an employee, they can contribute up to $23,000 a year plus a catch-up of $7,500 if they are over 50. Further, the business owner can contribute up to $46,000 as an employer match. The employee’s side of the contribution is subject to 25% of the total compensation, which the business owner must pay herself.
Example: Jessica, age 52, has a solo practice. She earns a W2 salary of $100,000 from her S-corporation. Jessica set up a solo 401k plan. In 2024, she can contribute $23,000 plus a $7,500 catch-up for a total of $30,500 as an employee of her company. Additionally, Jessica can add up to $25,000 (25% x $100,000) as an employer. All-in-all, she can save up to $55,500 in her solo 401k plan.
One important side note: if a business owner works for another company and participates in their 401(k), the above limits are applicable per person, not per plan. Therefore, the entrepreneur has to deduct any contributions from the second plan to stay within the allowed limits.
Add your spouse
A business owner can add his or her spouse to the 401k plan subject to the same limits discussed above. To be eligible for these contributions, the spouse has to earn income from the business. The spouse must report a wage from the company on a W2 form for tax purposes.
Reduce your current tax bill.
The solo 401k plan contributions will reduce your tax bill at year-end. The wage contributions will lower your ordinary income tax. The company contributions will decrease your corporate tax.
This is a very significant benefit for all business owners, particularly those who fall into higher income tax brackets. If an entrepreneur believes that her tax rate will go down in the future, maximizing her current solo 401k contributions now can deliver substantial tax benefits in the long run.
Opt for Roth contributions.
Most solo 401k plans allow for Roth contributions. These contributions are after taxes. Therefore, they do not lower current taxes. However, the long-term benefit is that all investments from Roth contributions grow tax-free. No taxes will be due when you start withdrawing during retirement.
Only employee contributions are eligible for Roth status. So, a solo entrepreneur can add up to $23,000 plus $7,500 in post-tax Roth contributions and $46,000 as tax-deductible employer contributions.
The Roth contributions are especially beneficial for young entrepreneurs or those in a lower tax bracket who expect their income and taxes to be higher when they retire. By paying taxes now at a lower rate, plan owners avoid paying much larger tax bills later when they retire, assuming their tax rate will be higher.
No annual test
Solo 401k plans are not subject to the same strict regulations as their corporate rivals. Self-employed plans do not require a discrimination test as long as the only participants are the business owner and the spouse.
If the company employs workers who meet the eligibility requirements, they must be included in the plan. To be eligible for the 401k plan, the worker must be a salaried full-time employee working more than 1,000 hours a year. In those cases, the plan administrator must conduct an annual discrimination test to assess the employee’s participation in the plan. As long as solo entrepreneurs do not hire any full-time workers, they can avoid the discrimination test in their 401k plan.
No annual filing
Another benefit of the 401k plans is the exemption from annual filing a form 5500-EZ, as long as the year-end plan assets do not exceed $250,000. If plan assets exceed that amount, the plan administrator or owner must do the annual filing. To learn more about the annual filing process, visit this page.
Asset protection
401k plans offer one of the highest bankruptcy protection of any other retirement account, including IRA. The assets in 401k are safe from creditors as long as they remain there.
In general, all ERISA-eligible retirement plans, like 401k plans, are sheltered from creditors. Non-ERISA plans like IRAs are also protected up to $1,283,025 (in aggregate) under federal law plus any additional state law protection.
Flexibility
You can open a self-employed 401k plan at nearly any broker like Fidelity, Schwab, or Vanguard. The process is relatively straightforward. It requires filling out a form, company name, Tax ID, etc. Most brokers will act as your plan administrator. As long as the business owner remains self-employed, doesn’t hire any full-time workers, and plans assets do not exceed $250,000, plan administration will be relatively straightforward.
As a sponsor of your 401k plan, you can choose to manage it yourself or hire an investment advisor. Either way, most solo 401k plans offer a broader range of investments than comparable corporate 401k plans. Depending on your provider, you may have access to a more extensive selection of investment choices, including ETFs, low-cost mutual funds, stocks, and REITs. Always verify your investment selection and trading costs before opening an account with any financial provider.
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