Have you heard the term “Solo 401(k)” and wondered what it is? The name basically describes the plan. It is a 401(k) plan with only one participant. This plan is for those who own their own business and do not have any employees, so the business owner is both employee and employer in the business. A solo 401(k) is the same as a regular 401(k), the total contribution limits and rules do not change; however, there are some things to know if you are contemplating setting up this plan. We will go through the main questions people ask when considering setting up a solo 401(k) for their business.
What is a Solo 401(k) plan?
As described above, it is a plan for business owners who have no employees. Spouses of the business owners can also be included in the plan. A 401(k) is a way to save for retirement. As a business owner, it is up to you to save for your own retirement. This plan is a way to save a large amount of money both from the business as the employer and out of your own paycheck as the employee.
What are the contribution limits for a Solo 401(k) in 2023?
As the employer, you can contribute up to 25% of compensation up to the annual dollar maximum of $66,000 for 2023. This is an increase of$5,000 from 2022. The IRS defines compensation as “earned income,” which is net earnings from self-employment after deducting one-half of your self-employment tax and contributions for yourself (basically it is your W2 income). You can use IRS help tools like this when deciding how much you are able to contribute.
Let’s use an example for illustration. Let’s say with the 25% compensation maximum, you have calculated that the business can add $36,000 into your solo 401(k). You can now add an additional $22,500 out of your paycheck from the business, making the total amount you are able to contribute that year $58,500. This is under the $66,000 dollar limit for 2023. This is also way more than most employees get into a 401(k) plan in a year. Employees are usually limited to their own $22,500 maximum, plus whatever the company matches, which is not usually as high as $36,000. This is a huge benefit of a solo 401(k)!
What is the solo 401(k) contribution deadline?
All solo 401(k) contributions must be made by the tax filing deadline which is April 15 of each year, or October 15 of each year if you filed for an extension. That said, the solo 401(k) plan creation documents must be signed by December 31, 2023, if you’d like to contribute for 2023.
What are the tax benefits of a solo 401(k)?
Well first, there are tax benefits for the business. The money the business adds to the solo 401(k) is tax-deductible to the business. Then, as the employee, you are often able to choose your tax treatment for your contributions as well.
If you want to take the tax deduction now, you can contribute to a traditional solo 401(k). If you want to let your money grow tax-free, you can contribute to a Roth solo 401(k). You pay the taxes now, but when you withdraw from a Roth solo 401(k) during retirement, you don’t pay a single dime in taxes.
Taking advantage of the Roth solo 401(k) would allow you to have the best of both worlds as a business owner. You get the tax deduction now for your business, adding pre-tax money into your solo 401(k). This money will grow tax-deferred and you will pay taxes on the withdrawal in retirement. Then, you also have the ability to have your own contributions be Roth. You pay income taxes on your individual income now, and then add the money to the Roth portion of the 401(k). This will grow tax-free and you will not pay any taxes on the withdrawals you take out during retirement. Having both types of money in your retirement portfolio will allow you to do strategic income tax planning throughout retirement.
How can I cover my spouse in the solo 401(k) plan?
If your spouse works for the business as an employee, meaning you are paying them and they are reporting those wages, they can also participate in the solo 401(k) plan. This would not change the rules of the solo 401(k) plan as it would if you hired an employee who was not your spouse. So, how much money can your spouse add? The limits are the same for your spouse as they are for you. Your spouse can add $30,500 annually out of their paycheck, and the business can add up to 25% of compensation.
What are the advantages of a solo 401(k)?
You can make significantly more contributions with a solo 401(k), because you are allowed to contribute both as an employee and employer. For 2023, you can contribute up to $22,500 as the employee, plus 25% of your compensation as the employer, totaling up to $66,000.Another major benefit is that you can choose between a Roth or a traditional pre-tax plan which means that you can choose which plan has the best tax advantage for you.
What are the drawbacks of a solo 401(k)?
While there are many advantages to a solo 401(k), there are also drawbacks. The biggest drawback of this plan is that if your business hires an employee, you must include that employee in the 401(k) plan, and adhere to all IRS testing requirements. This can become cumbersome and more costly for the business but isn’t necessarily bad. It is just something to be aware of. You cannot hire an employee and simply exclude them from the 401(k) and keep it to yourself as the owner.
Another drawback, which is not much of one at all, is that once the plan assets are over $250,000, the plan owner must fill out an IRS form 5500-EZ each year. Again, not much of a hassle, just a little extra paperwork.
How much does it cost to set up a solo 401(k)?
It depends on what solo 401(k) provider you choose. Many providers charge no fees to open a solo 401(k) and have minimal yearly maintenance fees. It is important to speak to a financial advisor to help you decide which solo 401(k) provider is right for you.
Who qualifies for solo 401(k)?
Unlike a regular 401(k), to qualify for a solo 401(k) you must be self-employed or be a small business owner. If you are an owner of a business, you cannot have any W2 employees, excluding yourself, your spouse or a business partner. There are no age or income restrictions.
How do I set up a solo 401(k) for my business?
To open a solo 401(k), you simply need to find a solo 401(k) provider. When you open a solo 401(k), the provider will usually create a solo 401(k) plan document for you. There are several solo 401(k) providers you can choose from. If you’re a fan of Vanguard, you can create a Vanguard solo 401(k). You can also create a Fidelity 401(k) or ETrade solo 401(k). One downside with a Vanguard solo 401(k) is it does not allow you to roll over an existing IRA into your Vanguard solo 401(k). One downside with a Fidelity solo 401(k) is it does not have a Roth 401(k) option. Do your research on the various solo 401(k) providers out there, and they will assist you in helping to set up the plan. It is actually quite simple once you choose a provider.
Set up a solo 401(k) for your business in 2023
After reading all of this, if you think a solo 401(k) might be right for your company and you want help setting up a solo 401(k), we highly recommend you use a tax professional and credentialed financial planner to ensure your plan is set up correctly and remains successful as you run your business. Schedule a complimentary discovery call with one of our financial planners.
You may also be interested in our blog about Solo 401(k) vs SEP IRA.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.