Article

Analytics, Managed Accounting

Retirement 101: Solo 401(k) Plans

Posted on May 3, 2024

By Michele Roletter

May 25, 2024

Are you starting to think about retirement? Whether you just opened a new business or have been steadily growing your company over the past few years, Solo 401(k) plans might be what you’re looking for.

A Solo 401(k) is a pre-tax retirement plan that allows business owners with no employees to save for retirement. In this plan type, you can contribute funds both personally and through employer contributions, helping you lower your business and personal taxable income.

In this article, we’ll cover everything you need to know about Solo 401(k) plans, including the tax advantages, eligibility, and contribution limits for self-employed individuals and small business owners.

What is a Solo 401(k)?

A Solo 401(k) is a traditional plan covering a business owner with no other full-time employees. Solo 401(k) plans can also cover the business owner’s spouse. On the contrary, traditional employer-sponsored 401(k)s are designed for business owners with employees. Both a Solo 401(k) and an employer-sponsored 401(k) follow the same rules and requirements.

There are only a few eligibility requirements to open a Solo 401(k). First, you must have an Employer Identification Number (EIN). This is a free process and can be completed online. The next stipulation is that your business must not have any full-time employees. If you pay full-time employees, you will need to open an employer-sponsored 401(k).

Solo 401(k) plans let you choose your contribution options. Traditional Solo 401(k) contributions are made on a pre-tax basis before any payroll taxes are calculated. Roth Solo 401(k) contributions are made with post-tax dollars.

Remember, your business structure does not dictate whether you can open a Solo 401(k). Instead, your employment status is what determines your eligibility. Sole proprietorships, LLCs, and corporations are all eligible to open a Solo 401(k), as long as you are the only employee.

Want to learn more? Book a meeting with us today!

Tax Benefits of a Solo 401(k)

Solo 401(k) offers a variety of tax benefits. For one, you can take advantage of pre-tax contributions to lower your taxable income in the year the contribution is made. The funds then grow tax-free until you withdraw the money during retirement. Business owners can also leverage Roth Solo 401(k) contributions. The funds you contribute to the 401(k) have already been taxed, resulting in tax-free growth and withdrawals during retirement.

Your personal tax situation will determine which strategy is best. For example, if your taxable income is higher now, it might make sense to take advantage of an immediate deduction rather than defer the taxes until retirement. On the contrary, if you are in a lower tax bracket, you might opt for Roth contributions.
Regardless of which deferral method you choose, you also have the opportunity to take a deduction at the business level for employer contributions. Just like an employer-sponsored retirement plan, Solo 401(k)s allow your business to make contributions on your behalf. These contributions are a qualifying business expense, helping you lower the income you pay taxes on and save for retirement.

Contribution Limits and Types

Similar to a traditional 401(k) plan, Solo 401(k) plans do have contribution limits. For the 2024 tax year, the Solo 401(k) contribution limit is $69,000, with an additional $7,500 catch-up contribution if you are over the age of 50. The $69,000 overall limit does come with limits for both employee and employer contributions.

Employee contributions, which are the contributions you make, are limited to $23,000 for the 2024 tax year. If you are over the age of 50, you can make an additional $7,500 catch-up contribution. Employer contributions are limited to 25% of your compensation defined by the plan or net self-employment income, which is found by taking your net profit minus half of your self-employment taxes.

Let’s say that your net self-employment income is $45,000. This caps your employer contribution at $11,250 for the year. It’s important to note that 401(k) contributions apply per person, not per business. This means if you hold a W-2 job and make 401(k) contributions, you could face more limitations.
Let’s say you earned $50,000 from a W-2 job and contributed $13,000. Assuming you were under the age of 50, your Solo 401(k) contributions would be limited to $10,000. Now, let’s say you earned $75,000 in net self-employment income. Your employer could contribute an additional $18,750 under Solo 401(k) rules.

How to Use a Solo 401(k) as a Tax Strategy

Solo 401(k) plans can be a great strategy for reducing taxable income. For one, you can deduct personal pre-tax contributions from adjusted gross income. Let’s assume you fall into the 22% tax bracket and you contribute $23,000 to your Solo 401(k). Your tax savings could be $5,060. Additionally, employer contributions are a qualifying business deduction, reducing the taxes you pay on profits. Let’s say that your business income before contributions is $45,000. If you were to contribute $5,000 as an employer contribution, you could reduce your taxable income by $5,000.

Assuming you pay 15.3% in payroll taxes on net profit and are in the 22% ordinary income tax bracket, you could save over $1,500 in taxes from making an employer contribution. Solo 401(k) contributions can be made up until April 15th of the next tax year. For example, contributions would need to be made by April 15, 2025 for the tax year ending December 31, 2024. If you extend your return, your contribution return is also extended to the new return deadline.

Investment Options in a Solo 401(k)

Solo 401(k) plans give you the opportunity to choose how your money is invested. The most common types of Solo 401(k) investments include stocks, bonds, mutual funds, and CDs. However, this type of retirement plan also allows you to invest in alternative investments, like real estate, notes, silver, tax liens, private equity, and gold.

Customizing your retirement strategy to fit your personal risk tolerance and financial needs is important to growing your retirement savings. For example, if you are nearing retirement, you can easily adjust your investment allocation to take on less risk. On the contrary, if you are a few decades away from retirement, you might choose to take on more risk, such as through private equity or other alternative investments.

Figures & Visual Aids

Figure 1: Solo 401(k) Contribution Limits

The below chart breaks down annual employee and employer contributions for the 2024 tax year.

Illustration depicting solo 401(k) plans' contribution limits: an employee side showing max $23,000 ($30,500 if over 50), and an employer side with 25% of

Figure 2: Tax Savings Example

Let’s say that your net self-employment earnings were $60,000 in 2023 and you had no other sources of income. If you didn’t make any personal or employer Solo 401(k) contributions, you would be assessed 15.3% in self-employment taxes plus ordinary income taxes. This would create the following tax liabilities:

  • Self-Employment Taxes – $8,478
  • Ordinary Income Taxes – $7,575

The net impact is over $16,000 in taxes on your $60,000 of net self-employment earnings. Now, let’s say you contributed $5,000 pre-tax to your Solo 401(k) and made an employer contribution of $6,000. Here are the taxes you can expect to pay:

  • Self-Employment Taxes – $7,630
  • Ordinary Income Taxes – $5,248

Contribution to a Solo 401(k) through employee and employer contributions totaling $11,000 resulted in $3,175 less in taxes. This is because the employer contributions reduced your taxable net self-employment income to $54,000. Then, your employee pre-tax contributions further lowered your ordinary income tax base by $5,000.

Figure 3: Growth Potential Over Time

Investing in tax-deferred accounts can significantly impact the value of your funds at retirement. For example, let’s say you contribute $500 a month to a taxable account over the next 20 years and your average tax rate is 22%. This means you are paying about $110 a month in taxes, netting your contribution to $390. The below graph shows your account growth over the 20 years, assuming a 10% growth rate.

A graph displaying total savings in solo 401(k) plans over 20 years, with lines for total contributions and future value (10.00%) each ending at approximately $36,000 and $

In 20 years, your account will have grown to $296,154. Now, let’s say you are able to put away the full $500 each month as tax-deferred contributions. Your account value will be over $80,000 more! This is the kind of leverage that Solo 401(k)s can provide.

Line graph showing the growth of total savings in solo 401(k) plans over years, comparing future value at 10.00% interest versus total contributions.

Rollovers and Transfers

It’s not uncommon for small business owners and entrepreneurs to have 401(k) funds from past employment positions. Instead of having your retirement funds in different accounts, you can roll over your funds to your Solo 401(k). Solo 401(k) rollovers are similar to any other type of rollover, with two main methods.

The direct method is the simplest way to transfer funds, with a check being written from your old retirement account to your Solo 401(k). The money is never in your account and goes directly to your Solo 401(k). The second method is an indirect rollover, where the old retirement account writes a check to you. You then have 60 days to put the funds in your Solo 401(k) before you are charged withdrawal penalties.

It’s important to note that there can be some tax due if you are rolling a traditional 401(k) into a Roth account. If this situation applies to you, it’s best to consult with a tax advisor. Nevertheless, a 401(k) rollover can give you more control of your retirement funds and open the door to new investment opportunities.

Solo 401(k) Loans and Withdrawals

If your Solo 401(k) has loan provisions built into the plan, you might be able to borrow funds. The maximum loan you can take from a Solo 401(k) is one-half of the present value of your vested account balance or $50,000, whichever is less. Let’s say that you have a vested balance of $40,000. Your maximum loan amount would be $20,000.

Solo 401(k) loans must be repaid within five years to avoid taxation, include both principal and interest payments, and have a legally enforceable agreement. Meeting all the qualifications of a Solo 401(k) loan can be difficult, which is why many business owners work with a professional.

Moreover, early withdrawals from Solo 401(k) plans are treated the same as any other employer-sponsored plan. If you withdraw the funds before age 59 1/2, you might be subject to a 10% early withdrawal fee and ordinary income taxes if you withdraw pre-tax contributions. There are exceptions to the early withdrawal penalty, like buying a first home, so be sure to consult with a professional before taking money out before retirement age.

Administrative Responsibilities

When you form a Solo 401(k), you generally serve as the plan administrator. This means you will need to manage the recordkeeping and reporting of your plan, including eligibility, documenting contributions, and detailing distributions. Records should be kept for at least six years.

Employers that have a qualified plan must file an annual report with the Department of Labor by July 31 of the following year. All plan activities will be reported on Form 5500. In addition, if you take withdrawals from the plan, you may also need to submit a 1099-R by January 31 of the following year.

Planning for Retirement

Too often, business owners and entrepreneurs focus on scaling their businesses and neglect to consider retirement. This can result in working well past retirement age and pinching pennies when it comes time to retire. A Solo 401(k) is a great option for contributing both business and personal funds to grow your nest egg.
Since Solo 401(k) contributions have a generous maximum contribution limit, this retirement plan is great for scaling businesses. Additionally, Solo 401(k) plans allow your spouse to make contributions, which is another advantage that can help you plan for retirement.

When establishing a Solo 401(k) plan, working with a financial advisor can be beneficial to pinpoint how much you should be contributing each year to reach your goals. Moreover, if you have a hard time remembering to make contributions, setting up automatic withdrawals for both employee and employer contributions is a great strategy.

Potential Pitfalls and Compliance

Solo 401(k) plans can come with pitfalls and compliance issues if not properly managed. Here are some common issues and how you can avoid them:

  • Bringing on Employees – Solo 401(k) plans can only be used if you are the only full-time employee. As your business begins to grow, you might hire employees. This isn’t allowed and will require you to open an employer-sponsored 401(k) plan.
  • Neglecting Annual Forms – Your Solo 401(k) plan might need to issue annual tax forms and file an annual report. Failure to submit this form could result in serious issues with the IRS. Be sure you mark your calendar or work with a professional to meet all of the applicable deadlines.
  • Avoiding Plan Documents – When you form your Solo 401(k), you should have a detailed plan document in place. This document will outline the basics, including qualifying income and loan eligibility. If the IRS ever looked into your plan, they would request this document.
    These mistakes can be avoided by keeping good records and adhering to contribution limits and deadlines.

Conclusion

A Solo 401(k) can be a great avenue to save for retirement while leveraging tax benefits, like lower business and personal income. However, Solo 401(k) plans do need to follow specific guidelines surrounding contributions, distributions, and rollovers.

This is why working with financial advisors and tax professionals is recommended. These professionals will be able to help you personalize your Solo 401(k) strategy to see the most benefits from this retirement plan. Contact our own team of tax experts to help you get the conversation started.

Steve Solt headshot

Michele is an accomplished Accountant, bringing a wealth of knowledge and expertise to her current CPA role at KDG. Experienced in Sage Products, Tax Preparation, GAAP, Financial Accounting and Managerial Accounting. Michele has spent her career overseeing tax preparation and accounting services at a multitude of organizations, even owning her own successful CPA firm.

Want to learn more? Book a meeting with us today!

Recent Posts
KDG logo

Navigate Tax Time with Ease

Our tax accounting solutions streamline your tax processes, ensuring compliance and maximizing efficiencies.

Share this post!

Explore More: Related Insights

  • Article
    Zoho Creator as a White-Label App Builder: Efficient, Affordable, & Customizable
  • Article
    What Are The Best Practices For AI In Healthcare? Explained!
  • Case Study
    Mount Aloysius College: Building a New Website for a New Generation of Learners