The Solo 401(k), often referred to as a Solo K for short, is a retirement account option growing in popularity that should be considered by the self-employed. Like other retirement accounts for the self-employed, the Solo 401(k) gives users the opportunity to make contributions and build their retirement savings with a variety of investment options. Certain advantages such as high contribution limits, flexibility in determining contribution amounts, and the availability of plan loans may prove an advantage that leads those who qualify to open an account to choose the Solo 401(k) as their retirement savings options. We’ll look at several of the features of this account type to see if it meets your needs.
Those who are self-employed and can use the Solo 401(k) as a convenient and cost-effective way to establish a 401(k) with profit sharing. You must be the only full-time employee of the business, but an exception exists if your spouse is the only other full-time employee.
Contribution limits are high relative to other account types, with 2018 total limits between employee contribution and profit sharing component of $55,000 plus an additional $6,000 for a total of $61,000 for those aged 50 or older.
The cost to create the plan is deductible as are contributions the business makes to the plan.
Select a custodian to open your account. You might base this decision on convenience, cost or a desire for specific investments. There are fortunately several quality custodians that offer Solo 401(k) plans. You will need to establish the account by December 31st of the year in which you’d like to make contributions, but you will have until the tax filing deadline (April 15th, for example) to make the contribution.
Be sure to verify all expenses associated with the plan at the custodian you select. Although substantially less expensive than full 401(k) plans, there may be annual administrative or account management fees in addition to those associated with the investments you select that may make the account more expensive than some retirement account types such as IRAs.
Those who have previously established retirement accounts may wish to consolidate them by rolling their balances into the Solo 401(k). This can prove administratively convenient and potentially reduce the cost of maintaining multiple accounts.
Roth contributions are available, although only for the employee’s contribution, limited to no more than $18,500 annually split between both traditional and Roth contributions. For example, you could contribute the entire amount as traditional pre-tax, the entire amount as Roth, or some combination of the two not to exceed the total limit. Those 50 or older will be able to contribute their catch up contribution to either side as well.
The employer profit-sharing component must be tax-deferred. This can be confusing for some savers since they are usually the businesses owner and only full-time employee, but let’s compare things to a regular 401(k) for a moment to make this distinction clear. For employees at a traditional company with a 401(k), you can make your own contributions ($18,500 annually for those under 50) however you wish between pre-tax and Roth contributions. Your employer’s match, however, must be a pre-tax contribution. Although they can match your Roth contribution, it will be in pre-tax money, not additional Roth money. This works similarly in your Solo 401(k) plan where you are both the owner and only full-time employee. Make your own allocations however you’d like (Roth vs pre-tax contribution) but the additional employer contributions will be tax-deferred.
The decision to make Roth or pre-tax contributions can be a challenge for some. It can seem as if you need to predict several aspects of your financial situation that may be difficult to forecast. What will my future income, tax rates, and other retirement account balances look like several years in the future? While you should always consult your tax and financial planning professionals in these matters for guidance as well, there is at least one course of action that makes sense for those without a compelling reason to contribute to one side or the other: split your contributions among Roth and pre-tax. When you have multiple “pools” of money in retirement (tax-free, taxable, tax-deferred), you can make your withdrawals strategically depending on your financial situation for the given tax year.
Solo 401(k) plans are allowed to offer loans to participants, although not all custodians of Solo 401(k) plans offer this as a feature. If your custodian does offer a plan loan, it will likely be at a competitive interest rate with convenient payment options, although there are limitations. You can take a loan of no more than $50,000 or one half of your account balance. For example, a saver with a balance of $30,000 could take a loan of no more than $15,000, while a saver with a $200,000 balance would be limited to the $50,000 maximum, not the half of balance limitation.
Keep in mind that your plan’s custodian may have additional limits beyond those stated for plan loans, as well as potential transactions costs for initiating a lone. As is the case with loans from all retirement account types, this should not be a first source of funds in an emergency. Your emergency savings account or unsecured lines of credit unassociated with your retirement savings may be a more advantageous source of funds if available.
There are limitations to consider. The most relevant limitation, inherent in the account title, is the restriction on a number of employees. Only one full-time employee plus an additional spouse are allowed. If more full-time employees are hired, another retirement account type should be selected.
There is also a limited amount of red tape, although much less than a standard 401(k). Keeping up with ERISA requirements as well as IRS annual contribution limitations will be the main tasks.
As you can see, Solo401(k) plans provide substantial advantages for those who qualify, although they are not a fit for all. If this sounds like a good option for you, make sure you give yourself some flexibility before the year-end December 31st deadline to complete all needed paperwork and good luck with this meaningful step in building retirement savings!