A CREDO TAX PLANNING STRATEGY SOLUTION
SOLO 401 (K) IRA: The Self-Employed Tax-Advantaged Retirement Plan
Through the Solo 401(k) IRA, self-employed business owners (and their spouses) can still reap the benefits of a retirement plan that has the same tax advantages as that of an employer-sponsored 401(k). In fact, with the Solo 401(k), you can save more for investment over other types of retirement accounts available to the self-employed. This guide helps you decide if this plan is the right choice for you.
The Solo 401(k) IRA or a one-participant 401(k) is a tax-advantaged retirement plan that is designed for the self-employed, business owners (who do not have full time employees), freelancers, and and their spouses . It is comparable to an employer-sponsored plan with a few distinct differences. Those who are employed full time may also save for a retirement in a solo 401(k) using their earnings from their side hustle.
In a solo 401(k), business owners are allowed to contribute both as an employer and an as an employee so they can get the most out of their retirement contributions and business deductions. Spouses who obtain income from the business are also allowed to contribute to their account. In the instance that the spouse of the business owner contributes as the employer, the same percentage of contribution would be received by the non-owner.
Small businesses that have more than one owner can also take advantage of this plan. In this set-up, there should only be one plan for the business with all the participants (owners) following only one set of rules.
SOLO 401(K) ELIGIBILITY RULES
No age or income restrictions
Must be self-employed / business owner with no employees
A couple running a business together also qualifies
BENEFITS OF SOLO 401(K)
Flexibility to choose when you want to deal with your tax obligation
There would be valuable tax advantages whether your choice of plan is a Traditional or a Roth Solo 401(k).
Traditional Solo 401(k)
With a Traditional Solo 401(k), you’ll be able to reduce your taxable income real time. This helps in reducing your tax bill. The money that you invest then grows tax deferred until your retirement. The withdrawals you make in retirement would be taxed as a regular income. Aside from the ordinary income taxes, there would also be a 10% penalty for the withdrawals you make from a Traditional Solo 401(k) before the age of 59 ½.
Roth Solo 401(k)
With a ROTH IRA, high earners are prevented from making contributions due to income caps. This is not the same with the Roth Solo 401(k). Just like with other Roth accounts, contributions made for Roth Solo 401(k) come from income that has been taxed already. But instead of a tax break upfront, the withdrawals made from a Roth Solo 401(k) after age 59 ½ are not taxable (for as long as withdrawals are made at least five years subsequent to making the contributions).
There may be penalties for withdrawals made in a Solo 401(k) prior to age 59 ½. With a Roth Solo 401(k), you won’t need to pay any tax or penalty for withdrawal of contributions (but not the investment earnings). However, since you cannot choose to withdraw contributions entirely, at least a portion of your withdrawals would be taxable and penalties may be imposed.
Higher annual contribution limits than a Plan IRA
As compared to a plain IRA, the Solo 401(k) has higher contribution limit. Take note though that the same applies to SEP IRA and the Keogh plan.
Spouses can invest in a Solo 401(k) also
Apart from the tax advantages, another benefit of a Solo 401(k0 is that your spouse who is also part of your business is also allowed to invest in the same plan (given that the spouse works for the business at least on a part time basis). The spouse is allowed to contribute up to $20,500 a year to a solo 401(k) for 2022. The spouse is also allowed to make catch up contributions of $6,500 (if 50 years old or older).
You (as your spouse’s employer) is allowed to contribute up to 25% of the (spouse’s) compensation. That is $61,000 in 2022, making it to more than $100,000 in tax-advantaged retirement accounts for you and your spouse.
Allows you to take loans from your account before you retire
Unlike many other retirement plans, with the Solo 401(k), you are allowed to take loans from your account prior to retirement. You are allowed to borrow up to the lesser of 50% of the plan value (or $50,000) which must be paid back in five years or less (except if the loan was used to buy a primary residence which gives you up to 30 years to pay).
Take note that borrowing from your own account does not mean there would be no costs that would be incurred. Taking loans from your Solo 401(k) account would require you to pay your account an interest that is comparable to that of a similar non-401(k) loan. You also have to remember that taking a loan from your account would mean that you would miss out on possible profits that your money would have kept it invested. The money that you borrow back from your account (including the interest) might be less than the returns that your would have earned if your money is left invested in the stock market.
Relatively simple in terms of paperwork
The Solo 401(k) is fairly simple in terms of paperwork, as it is intended for one-person businesses (not corporations).
Traditional 401(k) or Roth Solo 401(k): Which one should you choose?
The decision to choose between the Traditional or Roth Solo 401(k) depends on your discernment if you will be in a lower tax bracket today once you retire. The Roth Solo 401(k) is the ideal choice if you believe you are paying lower taxes now. The Traditional Solo 401(k) is your better bet if you foresee belonging to a lower tax bracket in retirement. Another thing to consider when choosing Roth Solo 401(k) is the contribution limit ($20,500 in 2022) and a catch up contribution of $6,500 (if you are age 50 or older). Saving more that the said amount means you would need to contribute the extra into a Traditional Solo 40(k) account (in which you can contribute to a Solo 401(k) both as an “employer” and an “employee”, but the “employer contributions are not allowed to be saved in a Roth account). Credo believes that it’s a smart move to hedge your bets for any tax circumstance by investing in a mix of pre-tax and after-tax retirement accounts so you will have room for strategy in the future. The decision to choose is based on the age, income, location, and preference.
SOLO 401(K) CONTRIBUTION LIMITS
Total of up to $61,000 in 2022, with an additional $6,500 catch-up contribution if 50 or older.
Read More About Solo 401(k) Contribution Limit
The contribution limits for Solo 401)k) is $61,000 in 2022 (or 25% of your net adjusted self-employed income. Including the catch up contribution of $6,500 (if age 50 or older), the contribution limit total would be $67,500 in 2022.
With a solo 401(k), contributions can be made both as an “employee” and an “employer.” As an employee, the contribution limit is $20,500 in 2022, or up to $27,000. As an employer, the contribution limit is up to 25% of your net adjusted self-employed income.
Note: The IRS calculates your net earnings from self-employment less one-half of your self-employment tax and employee contributions you made for yourself.
What are the contributions limits if you participate in another 401(k) plan?
The limits on employee contributions are collective across all accounts if you have a Solo 401(k) account and at the same time you are employed in another company wherein you participate in its 401(k) plan. The contribution limits of the employer are based on plans which means that two different (and unrelated) employers can contribute up to the employer maximum annually.
If you are considering a Solo 401(k) with the goal of saving from a side job for retirement should consult fist with Credo as our tax professionals can help confirm if you are eligible for the account (including your self-employment status).
SOLO 401(K) WITHDRAWALS
You owe taxes or penalties on Solo 401(k) withdrawals depending on which type of account you withdraw from (Traditional or Roth) and when the money was withdrawn from your Solo 401(k).
The rules for early withdrawal for Solo 401(k) are dependent on the type of account that you have. Given a few exceptions, there is a 10% penalty tax on withdrawals from a Traditional Solo 401(k) account made prior to turning 59 ½ years old (plus income taxes on the withdrawn amount).
Early withdrawals of contributions with a Roth Solo 401(k) are tax free (both penalty tax and income tax). But take note that the earnings are subject to penalty and income taxes. You are allowed to withdraw contributions exclusively which means that there would be taxes and a penalty on the least part of any early withdrawal.
There are certain instances wherein the IRS waives the 10% penalty for early withdrawals. Take note that there would still be taxes on any contributions or earnings that have been taxed. The following are the exceptions:
- Medical expenses exceeding 10% of the adjusted gross income
- Permanent disability
- Certain military service
- A Qualified Domestic Retirement Order (QDRO) issued as part of a divorce or court-approved separation
The 401(k) owner doesn’t need to pay any income tax (and the recipient can defer taxes by rolling the distribution into an IRA) in the case of a distribution paid to an ex-spouse under a QDRO.
A Solo 401(k) (unlike an IRA or SEP IRA) doesn’t permit penalty-free withdrawals for higher education expenses or first-time homebuyers.
There are no penalties that would be incurred for withdrawals from the Solo 401(k) after age 59 ½ . But there would be income taxes depending on the type of account. Having a Roth Solo 401(k) means that you won’t need to pay any tax or penalty for withdrawal of contributions (but not the investment earnings) if made at least five years after the first contribution to the account. If you have a Traditional Solo 401(k), income taxes are paid on withdrawals made based on your current tax bracket.
A Solo 401(k) obliges you to eventually make withdrawals from your account. This is called as required minimum distributions (RMDs). The RMDs requirements can be avoided by rolling a Roth Solo 401(k) into a Roth IRA (which does not have mandatory RMDs). For Solo 401(k)s, you must take your first RMD by April 1 of the year after you turn 72. And in the following years, RMDs must be taken by December 31st of the relevant year.
PROCESS IN OPENING A SOLO 401(K)
Timing is crucial when opening a Solo 401(k). Deadline for establishing a Solo 401(k) for you and your business is December 31st of the year when you plan to contribute.
Step 1: Choose Your Provider
Choose a broker whose investments you prefer. Make sure the broker has the Roth Solo 401(k) option as it is not commonly offered as compared to the Traditional Solo 401(k) plan.
Step 2: Get an EIN Number
Secure an Employer Identification Number from the IRS (this is essentially a tax ID for employers).
Step 3: Fill Out an Application and Any Required Plan Documents
Your broker would provide the documents required by IRS for your retirement plan. They should be able to guide you through the process.
Step 4: Fund the Account
Your Solo 401(k) account can be funded by either setting up a transfer from a savings or a checking account or by rolling over money from another retirement account.
Step 5: Choose Investments
You are free to determine how you want your money invested (just like in any other retirement account).
SOLO 401(K) VS SEP IRA
Small business owners choose between Solo 401(k) and SEP IRA (Simplified Employee Pension) when saving for retirement (both have tax benefits). Though there are a few distinct differences that make the Solo 401(k) standout.
Save more with a Solo 401(k)
You may be able to save more with a solo 401(k). Unlike in SEP IRA, with Solo 401(k), your total contributions can exceed to up to 25% if your net adjusted self-employed income (up to the maximum of $61,500 in 2002). In fact, you may be able to save more in a Solo 401(k) especially if you have a substantial income in your business. And just like in any employer-sponsored 401(k), the contributions can be made both by the “employer” and the “employee” in which you are allowed (as an “employee”) to contribute up to 100% of your net adjusted self-employed income or up to $20,500 in 2022 whichever is less. As an “employer”, you are allowed to contribute up to 25% of your net adjusted self-employed income. Furthermore, those who are 50 years old or older are allowed to make additional catch-up contributions of $6,500 per year.
The Roth Solo 401(k) Option
You may choose the Roth Solo 401(k) option if you want to make tax-free withdrawals in retirement. With SEP IRAs, you are only allowed pre-tax contributions and there is no option to have a Roth account.
Catch Up Contributions for 50 or Older Savers
Those who are 50 years old and above can contribute to a Solo 401(k) or a SEP IRA an all-in maximum of $61,000 in 2022 (whether you sign up for the plan as an employer or as an employee). However, in a Solo 401(k), savers who are 50 years old and older are allowed to make additional catch-up contributions up to $6,500 (as an employee). With SEP IRAs, catch-up contributions are not allowed since only employer contributions fund the account.