What is a Solo 401(k)?
A Solo 401(k), also called an Individual 401(k), is a retirement account available only to self-employed people with no full-time employees. The only exception to this rule is if you employ your spouse. If that's the case, you can also contribute on their behalf.Â
Here are seven reasons why its a smart move to open a Solo 401(k)
1. Opening an account is easy
Opening a Solo 401(k) can be done by taking a few easy steps. All you’ll need is your Employer Identification Number (EIN). If you don’t have an EIN, you can apply for one through the IRS website. In most cases, it is assigned within minutes.Â
Once you have an EIN in hand, opening a plan is as simple as finding a broker you want to work with (in person or online) and filling out a Solo 401(k) account application. Once that’s done, you’ll review and sign a plan adoption agreement. And that’s where the fun begins.Â
2. A Solo 401(k) is customizable
Once your account is up and running, you’ll have access to the same types of investments as major corporations. Besides traditional stocks and bonds, you’ll have the opportunity to invest in precious metals, tax liens, and real estate. The options are staggering, meaning you can customize your retirement account to meet your goals and risk tolerance.
You also have the option of creating a Solo 401(k) or a Solo Roth 401(k). The difference is that you’ll only pay taxes on the Solo 401(k) when you begin withdrawing the money. With a Solo Roth 401(k), you have two options:
Pay no taxes on the money now and wait to pay taxes in retirement.
Pay taxes on the funds now and pay no taxes on the money in retirement.Â
3. Tax savings
If you opt for a traditional Solo 401(k) -- or do not employ the Roth feature of a Solo Roth 401(k) -- the funds you invest will not be taxed until you begin withdrawing money in retirement.
Let’s say your business brings in $60,000 annually, and you’re in the 22% federal tax bracket. Now, imagine you want to put $20,000 of that income into a Solo 401(k). Rather than pay 22% in federal taxes on $60,000 ($13,200), you’ll only owe taxes on $40,000 ($8,800). Right away, you save $4,400.Â
4. Outstanding contribution limits
As a business owner, the IRS considers you both the employee and employer. That fact alone offers a tremendous opportunity to make the most of your 401(k). Using the same scenario, let’s imagine that your business is bringing in $60,000 annually, and you want to maximize your contributions.
As the employee: You contribute the annual limit of $20,500.Â
As the employer: You contribute 25% of your annual income, or $15,000 ($60,000 x 0.25 = $15,000).
In one year, you invest a total of $35,500 toward retirement. What’s more, you can knock that $35,500 off your earned amount and only pay taxes on the remaining $24,500.Â
The more you earn, the more you can invest – up to an annual limit of $57,000. And if you'd like, you can do the same for a spouse who works for the business full-time.Â
Bonus: If you’re 50 or over, your contribution limit is bumped by $6,500 to $27,000. If you opt to invest the full amount as both the employee and employer, your total contribution would be $42,000.Â
5. Contribution limits beat most corporate 401(k) limits
To be clear, 401(k)s, in general, are an excellent tool for building wealth. But to illustrate how helpful a Solo 401(k) can be, let’s compare it to the 401(k) offered by many employers.Â
If you max out your annual contributions and your company matches up to 3%, the math would work out like this:
Your contribution: $20,500
Employer’s contribution: $615
Total annual contribution: $21,115 (or $27,810 if you’re 50 or older)
6. Available for business funding
If you ever need to inject money into your business, a Solo 401(k) allows you to borrow up to $50,000 of your invested funds!
7. May allow for hardship withdrawal
As long as you meet certain conditions, a Solo 401(k) plan allows you to withdraw funds from your retirement account.Â
Saving for retirement does not have to be one of the many challenges you face as a business owner. Even if early investments are small, compound interest can help your nest egg grow.Â