Designated retirement accounts create an investment vehicle with tax-preferred treatment. One of the most popular is the company-sponsored 401k. But you might also qualify for a Solo 401k, which is tailored to entrepreneurs and provides additional opportunities to set aside funds in tax-preferred accounts.
Here’s what you need to know about Solo 401ks:
The Solo 401k is an approved plan established in 1962 and enhanced in 2002 through the EGTRRA (Economic Growth and Tax Relief Reconciliation Act). The Act popularized the IRA and made valuable changes, including the following:
- Increased contribution limits on Solo 401ks and allowed up to 100% of compensation.
- Added catch-up contributions for everyone over 50.
- Established Roth contributions for 401k and 403b plans.
- Adjusted contribution limits to inflation.
- Made accounts more portable.
Solo 401ks tend to follow standard 401k rules without being subject to ERISA laws, making plans costly and complex. ERISA protects participants and beneficiaries. With no employees to defend, the IRS permits the simplified 401k for individuals.
Who Qualifies for a Solo 401k
The IRS does not place age or income restrictions on a Solo 401k, and if you own a business, you can participate even if you have an employer-sponsored plan. To qualify, you must be self-employed with no employees. The only exception is your spouse if they earn taxable income from the business.
Not all employees disqualify you for a Solo 401k. However, the IRS does not allow any qualified W-2 employees, even if they are not interested in participating. A qualified employee is eligible if they meet the following criteria:
- Non-union workers over 21.
- Resident aliens.
- Employees working more than 1,000 hours annually (19+ hours a week). In 2024, due to the SECURE Act, the maximum number of hours worked falls to 500 hours a year.
Hiring an eligible employee disqualifies you from making additional contributions to the Individual 401k, and you must rollover the account to a Roth or traditional IRA within a year.
Contribution Limits on Solo 401ks
The IRS allows individual and employer contributions. In 2022, the individual contribution limits are as follows:
- Employee: up to $20,500 up to 100% of income.
- Employee catch-up: up to $6,500 for a maximum employee contribution of $27,000
- Employer: up to 25% net self-employment income.
The maximum contribution from both employee and employer in 2022 is $61,000 and $67,500 for those over 50. Funding limits are per person based on individual income.
Taxation of Solo 401ks
You may contribute to a standard or self-directed, Traditional, or Roth 401k. The difference is the tax treatment.
Traditional 401ks defer taxes, allowing you to deduct contributions lowering taxable income in the contribution year. You pay taxes on the total account balance at the time of withdrawal.
Roth IRAs grow tax-free. You do not get an initial tax benefit but withdraw the total amount, including gains tax-free in retirement.
You can divide contributions across multiple accounts up to the maximum limit per person.
UBIT (Unrelated Business Income Tax): The IRS can tax profits through UBIT, even though retirement accounts receive preferred tax treatment. Unlike IRAs, Solo 104ks typically avoid UBIT taxation.
Rules Regarding Solo 401ks
Distributions: Withdrawals from a Traditional 401k before 59 ½ generally result in a 10% penalty plus taxation on the distribution. There are limited exceptions that waive the penalty.
Roth IRAs follow the 59 ½ rule on gains, and you must own the account for at least five years to avoid a penalty. You may withdraw contributions prior to 59 ½ without penalty.
Traditional individual 401ks also require distributions beginning at the age of 72 in the form of RMDs.
Loans: The IRS allows loans of up to $50,000 or 50% of the vested balance, whichever is lower. The maximum repayment is five years.