What A Solo 401(k) Can Do For You

What A Solo 401(k) Can Do For You

February 14, 2024

In pursuing financial independence and retirement security, many Americans are turning to self-employment and entrepreneurship. For those who venture into solo businesses, the Solo 401(k) emerges as a powerful tool, offering unique benefits and opportunities for long-term wealth accumulation

A Solo 401(k) offers all the perks of big employer-sponsored 401(k) plans – tax breaks for savings, tax-deferred or tax-free growth, and a generous annual maximum contribution. The best part? You can enjoy these benefits even if you're running a small business. 

These advantages make the Solo 401(k) better than other self-employed programs like the SEP-IRA and SIMPLE IRA. Here's what you need to know.

What Is A Solo 401(k)?

The Solo 401(k), also called Solo-k, Uni-k, or One-participant k, is designed for individuals who operate their businesses without employees, except for a spouse. It is an excellent retirement savings option, empowering entrepreneurs with a tax-advantaged method to prepare for the future. 

A standout feature of the Solo 401(k) is its generous contribution limits. Contributions can be made to the plan in both capacities. The owner can contribute:

  • Elective deferrals of up to 100% of compensation (also known as "earned income" for self-employed individuals) up to the annual contribution limit of $22,500 in 2023.
  • Employer nonelective contributions of up to 25% of compensation as defined by the plan. For self-employed individuals, specific guidelines apply. 

As of 2023, individuals can contribute up to $66,000 annually as an employee and an additional 25% of their net income as an employer contribution. This higher ceiling allows for accelerated wealth accumulation, putting you on a faster track to achieving your retirement goals. 

Understanding Solo 401(k) Tax Advantages

Unlike traditional employer-sponsored 401(k) plans, a Solo 401(k) often provides a broader range of investment options. This flexibility allows you to diversify your portfolio and tailor your investments to align with your risk tolerance and financial goals. This dual tax advantage can significantly enhance your overall wealth-building strategy.

One notable distinction between the solo 401(k) and other self-employed retirement plans is employee contribution limits. With the solo 401(k), individuals can contribute their entire salary to the annual maximum without being confined to just 25 percent of their salary, as seen in other plans. While this feature can help minimize taxes, it's important to note that these contributions don't exempt them from the self-employment tax.

Beyond this, the solo 401(k) functions similarly to other 401(k) plans, whether it's a traditional or a Roth 401(k). Suppose you opt for tax-deductible contributions when setting up your solo 401(k). In that case, it operates like a traditional 401(k), allowing you to contribute pre-tax funds and enjoy tax benefits in the current year. Conversely, if you choose a Roth option, you'll make after-tax contributions but reap the rewards of tax-free withdrawals during retirement.

Potential Drawbacks of A Solo 401(k)

The Solo 401(k) shares many drawbacks of typical 401(k) plans, along with a few specific to itself. Like other 401(k) plans, early withdrawals from a Solo 401(k) before retirement age 59½ may incur taxes and penalties. While loans and hardship withdrawals are options, they should be considered as last resort.

Additionally, setting up a Solo 401(k) may require more paperwork, although it's manageable. Unlike opening a typical brokerage account online in just 15 minutes, the Solo 401(k) process may be slower. You'll also need to obtain a tax ID from the IRS, which can be done online. Furthermore, you'll manage the plan, select investments, and help ensure compliance with annual contribution limits.

Another consideration is that once the assets in your Solo 401(k) cannot exceed $66,000 by the end of the year. While these drawbacks aren't overly unmanageable, it's important to know them before deciding on a Solo 401(k).

How to Open a Solo 401(k)

If you wish to open a Solo 401(k) on your own, here is our 4-step "how-to" guide. If you require assistance in managing the funds within your solo 401(k), our fiduciary advisors are here to help.

  • Step 1: Determine Eligibility
    • No age or income requirements; must be a business owner with no employees.
    • Businesses must be actively engaged in a for-profit enterprise.
    • Self-employed individuals eligible, including sole proprietors, independent contractors, and partners.
  • Step 2: Find a Provider
    • Choose a Solo 401(k) provider offering direct and affordable plans with diverse investment options.
    • Consider factors like costs, plan options, and investment variety.
  • Step 3: Gather Documents
    • Employer Identification Number (EIN)
    • EIN for Solo 401(k)
    • Beneficiary Information
    • Personal Identification
    • Bank Account Information
  • Step 4: Open Your Account
    • Ensure all necessary documents are ready.
    • Open an account before April 15th for tax benefits or after year-end for prior-year contributions.

Keep in mind that as your plan progresses, additional paperwork may be necessary—specifically, the IRS mandates an annual report on Form 5500-SF if your 401(k) plan holds $250,000 or more in assets at the conclusion of a given year.

Is A Solo 401(k) Worth It?

The flexibility surrounding contributions, investment choices, and minimal management requirements of a Solo 401(k) make it an appealing option for small business owners or sole proprietors actively looking to save for retirement.

Both salary deferral and income-sharing contributions are discretionary and can be adjusted as needed. Depending on your business's varying profitability, you can contribute through either method or choose not to contribute in a particular year. 

Moreover, contributions to your Solo 401(k) offer opportunities to capitalize on other tax incentives, potentially leading to significant long-term savings. Working with a fiduciary advisor can be beneficial in deciphering if this plan is right for you.

How A Fiduciary Can Help

The Solo 401(k) can be a powerful vehicle for retirement savings. However, navigating the complexities of investments, compliance, and regulatory requirements can be challenging. This is where a fiduciary comes into play. Their experience can guide you in selecting the most suitable investment options within your Solo 401(k) to align with your risk tolerance, time horizon, and financial goals. 

At Agemy Financial Strategies, our team of fiduciary financial advisors is here to walk you through the process of achieving renewable wealth so that your money can work hard for you and you can reap the benefits of a comfortable retirement. Here are just some of the many ways we can help our clients:

  • Goal Setting: We will help you establish clear and attainable retirement goals, crafting a personalized financial blueprint to realize your retirement lifestyle aspirations.
  • Risk Assessment: Identifying potential financial risks is the cornerstone of our approach. Solo 401(k) plans come with specific rules and regulations that must be followed to maintain their tax-advantaged status. A fiduciary can help ensure that your plan complies with ever-changing tax laws and regulations, reducing the risk of penalties and setbacks.
  • Portfolio Management: Our experience extends to implementing and managing a diversified investment portfolio meticulously aligned with your long-term objectives and risk tolerance.
  • Regular Reviews: Beyond managing your Solo 401(k), a fiduciary can help you develop a comprehensive financial plan encompassing your entire financial picture. This includes tax planning, risk management, estate planning, and other critical components contributing to your financial well-being.

Last Thoughts

The perks of self-employment are plenty, but there’s at least one significant drawback: the lack of an employer-sponsored retirement plan like a 401(k). In the quest for financial independence, the Solo 401(k) stands out as a promising tool for solo entrepreneurs. Its high contribution limits and tax advantages can significantly boost your retirement savings. However, partnering with a fiduciary is valuable in navigating the complexities for long-term success.

At Agemy Financial Strategies, you can rest assured knowing that your financial affairs are in capable hands. Our priority is helping you take care of yourself and your family. We want to learn more about your situation, identify your dreams and goals, and provide you with the highest level of service.

If you want to learn more about how we can help you manage your wealth, schedule a complimentary strategy session here today.