Unlock the Concert of Benefits of a Solo 401 (k) for the Self Employed
John F. Dennehy Jr., CPA, PC

Unlock the Concert of Benefits of a Solo 401 (k) for the Self Employed

Small business owners represent the life and heartbeat of the United States economy. There are a staggering 31.7 million small businesses spread out across different industries. 

Small business owners enjoy an array of benefits associated with ownership, including independence, financial rewards, exceptional lifestyle, the ability to write off business expenses for taxation, following their passion, and more.

While a small business owner enjoys a myriad of benefits, the lack of a standardized retirement plan isn't among the pros. Fortunately, there are a range of different retirement accounts designed just for small business owners.

And one of the most attractive types of retirement accounts is the solo 401(k). Let's take a closer look at the solo 401 (k) plan, what it means, and the key benefits involved with this small business owner retirement plan.

What Is a Solo 401 (k) Plan Retirement Account?

Although some employers offer employees different retirement account access — such as employer profit-sharing contributions, defined contribution plans with employer contribution, and more — the costs and time associated with administering a plan can make it virtually impossible for a small business owner. Yet, a solo 401 (k) plan may be suitable.

The solo 401 (k) is uniquely designed for a small business owner who has no employees. IRS rules say you are not able to contribute to a solo 401 (k) if you have full-time workers. You can, however, use the solo 401 (k) plan as a vehicle for you and your spouse to save for retirement.

The solo 401 (k) is arguably the best option for sole proprietors, one-person businesses, or spousal partnerships because of how quickly you can amass money in the plan. 

The solo 401 (k) offers small business owners all of the attractive benefits of participating in a big employer's 401(k) plan, such as generous annual maximum contribution limits, tax-free or tax-deferred tax advantages, and the ability to make tax-deductible contributions.

A solo 401 (k) can be even better and more attractive than the traditional 401 (k). This is because you are typically not hindered by restrictive rules on the kinds of investments you can make as you are in a standard 401 (k). 

These special features may also make the solo 401 (k) even more advantageous than other programs for self-employed individuals, such as a SIMPLE IRA or Simplified Employee Pension.

At-a-Glance Look of What You Should Know About the Solo 401 (k) Plan

A solo 401 (k) — also called a one-participant 401 (k) plan — is an individual-style 401 (k) that offers all the benefits of a traditional employer-sponsored retirement plan. The solo 401 (k) offers high contribution limits and the ability to save for retirement with tax-free income or eligibility for a tax break. 

Here are a few simple things you should know about the solo 401 (k).

Who Is Eligible to Use a Solo 401 (k)?

To participate in a solo 401 (k), you must be a business owner and have no employees. There are no age or income restrictions.

What Are the Annual Contribution Limits?

The annual contribution limit for solo 401 (k) retirement plans can be different based on your age. And the total contribution limit tends to change and is adjusted every year — with higher contribution limits each subsequent year.

When you're a business owner in a solo 401(k) plan, you will essentially wear two hats: employee and employer. As such, you can make contributions in both capacities.

  • You can contribute elective deferrals or employee deferral contributions of up to 100% of your compensation up to the annual contribution limit.
  • Total contributions to your solo 401 (k) in 2022 can't exceed $61,000 (not including catch-up contributions.)
  • Those 50 and older can make a catch-up contribution of $6,500 in 2022. The catch-up contribution can be paramount for those nearing retirement who may not have the desired financial outlook.

How Are Solo 401 (k) Contributions Taxed for Self-Employed Individuals?

Whether you make employer contributions or employee contributions to your own solo 401 (k), will enjoy taxed advantaged benefits:

  • Traditional solo 401 (k) plan contributions are made with pre-tax dollars, which can reduce your taxable income for the year. This can help you gain a tax break today.
  • Roth solo 401 (k) plan contributions for self-employed individuals are made with after tax dollars. This can potentially reduce your tax liability when you pay taxes in retirement and give you a tax break in retirement.

How Are Solo 401 (k) Retirement Distributions Taxed for Self-Employed Individuals?

Because of the tax treatment of contributions, traditional ira and traditional solo 401 (k) disbursements are taxed differently.

  • Traditional solo 401 (k) plan distributions are taxed as ordinary income when you take the money out in retirement. You have received the initial tax break (tax deferred income) on a traditional solo 401 (k) when you contribute to the retirement plan with tax-free dollars.
  • Roth solo 401 (k) plan qualified distributions are taken tax free. The tax benefits of these retirement plans means you could pay lower taxes on income in retirement.

Unraveling the Many Benefits of Solo 401 (k) for Self-Employed

Now that we have explained the solo 401 (k), let's explore the many benefits of these types of accounts that other retirement accounts may not offer. Here are a few.

Unlimited Investment Options for Self-Employed People

With a solo 401 (k), you — as the business owner — can put your money to work how you see fit. You aren't limited by the investment menu of your employer. 

Instead, you can use your solo 401 (k) proceeds in:

  • Mutual funds,
  • Cryptocurrency,
  • Real estate,
  • Mutual funds,
  • Private loans,
  • Exchange-traded funds,
  • Private investments, and
  • Much more.

You can even work with a wealth management firm, or financial institution, or receive investment advice to maximize your account in a tax-deferred or tax-deductible way.

Need to Make an Investment or Fund Business Activities?

A solo 401 (k) participant is allowed to borrow up to $50k for any reason, including to make an investment into the business.

Few Restrictions

A solo 401 (k) has no age or income restrictions. The key restriction is that you must be a business owner and have no employees. 

Fortunately, a business owner's spouse doesn't qualify as an employee. However, to start a solo 401 (k) a self-employed person would need an employer identification number.

High Contribution Limits

The solo 401 (k) plan has very high and extremely flexible contribution limits. In most instances, the solo 401 (k) allows more contributions than a traditional IRA, Roth IRA, SEP IRA, or SIMPLEs. 

With a solo 401 (k), business owners can even contribute up to 100% of their salary vs 25% as with other plans. This feature can empower you to minimize your taxes. However, this key feature doesn't help a business owner avoid the self-employment tax.

Easy to Open

Opening a solo 401 (k) plan is relatively easy. As long as you have an employer identification number, you can open a solo 401 (k) with online brokers. 

Because the solo 401 (k) is pre approved, you'll never have to worry with a complex plan adoption agreement. The plan adoption agreement will typically be managed by online brokers.

No Testing

No one likes tests. And the complex tests required in the administration of a traditional 401 (k) can be intense. Fortunately, the solo 401 (k) doesn't require any testing. 

As long as you have no common-law employees, you're not required to perform nondiscrimination testing because there are no employees to receive unfair benefits. However, if you hire employees, you will be required to meet certain testing requirements.

Contact John F. Dennehy CPA

As a small business owner, it makes dollars and sense to start and contribute to a solo 401 (k). In addition to saving for your future, you can maximize the employer contribution to enjoy tax benefits and better retirement outcomes. 

And the team at John F. Dennehy can help. We are a group of experienced Certified Public Accountants who specialize in helping business owners understand contribution rules and optimize their retirement portfolios. We will work closely with you, offering tax advice to help you achieve your goals.

Contact John F. Dennehy CPA today

About the Author John F. Dennehy Jr., CPA, PC

We at John F. Dennehy CPA are a team of certified public accountants who service clients throughout Long Island. The services that we provide are comprehensive, and we can resolve multiple accounting needs for a client.

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