The flexibility and control a solo 401(k) offers can help the self-employed put away more money than traditional or Roth IRAs allow and enjoy certain tax benefits.

Saving for retirement is something many people put off until later, but that’s a big mistake. A 2018 Federal Reserve report found that nearly one-quarter of American adults don’t have a pension or any retirement savings. For self-employed individuals and small business owners, it can be even harder to save for retirement.

It’s important not only to save but also to put your money to work in appropriate investment vehicles. One option is a solo 401(k) qualified retirement plan, which allows self-employed individuals and small business owners to save retirement funds with pretax contributions. This type of plan gives you the opportunity to save significant amounts of money each year—and also provides certain tax benefits.

In contrast to a solo 401(k), a regular 401(k) is a type of retirement account sponsored by an employer. When you save a percentage of your paycheck, the company makes an employer contribution, which often matches the employee contribution up to a specified percent. With a solo 401(k), you can make contributions as both the employer and the employee.

Who’s Eligible?

Before you get started, it’s important to understand the eligibility requirements to open a solo 401(k). A solo 401(k) is a retirement account designed for self-employed individuals or small business owners with no full-time employees other than themselves and their spouse. There are no restrictions on age or income.

Advantages of a Solo 401(k)

One of the most popular features of a solo 401(k) is that it allows you to have checkbook control over your retirement funds. Checkbook control is the ability to write checks directly from your retirement account to make investments. This ability to pay expenses and have direct access to your retirement funds provides greater flexibility.

Another benefit of a self-directed 401(k) is it provides an exemption from Unrelated Business Taxable Income (UBTI), which includes Unrelated Debt-Financed Income (UDFI). UDFI refers to income generated by debt-financed assets held within a tax-exempt entity such as a retirement account. This type of income can be subject to UBTI tax, which can significantly reduce the investment returns from your retirement account. If you set up a solo 401(k) plan, however, you may be able to avoid UDFI and UBTI tax altogether.

With a solo 401(k) retirement plan, you can make larger contributions than you can with other types of retirement accounts (e.g., traditional or Roth IRAs). Additionally, the contributions you make to a solo 401(k) are tax-deductible, meaning you can reduce your taxable income for the year. Plus, you have the ability to loan yourself money.

It’s important to understand, however, that every advantage of using a solo 401(k) comes with things to be aware of. If you want to set up and manage a solo 401(k) plan, be prepared to put in time and effort. You’ll need to think carefully about the plan design, choose a custodian or trustee, and ensure all contributions and distributions are properly recorded and reported. For some self-employed people, this can be a lot of work and might discourage them from setting up a solo 401(k). It’s up to you to make sure the plan follows all IRS regulations. This means filing annual reports, making contributions on time, and investing only in permissible assets. If you don’t comply with these rules, you could face some hefty fines and tax consequences.

Contribution Limits and Rules

A solo 401(k) contribution has two standard parts: an employee salary deferral contribution and an employer profit-sharing contribution. The maximum salary deferral contribution for 2023 is $22,500. If you are 50 or older, an additional $7,500 catch-up contribution is possible for 2023.

Employer contributions can be 25% of employee salary or 20% of business earnings, depending on the business’s organization. The combined employee and employer maximum contributions are subject to the lesser of 100% of compensation or $66,000 in 2023. Also, contribution levels for salary deferrals and profit sharing can be adjusted as business income fluctuates.

How Can I Open a Solo 401(k)?

Most online brokers and some custodians can help you set up a solo 401(k). You’ll need an employer identification number (EIN) first. The custodian provides the paperwork, which includes a plan agreement and account application. Some custodians, though very few, even offer an online platform where one can set-up, manage, and invest through their account—all online and with one system. At Quest and the other few custodians that offer this, managing a solo 401(k) can be quite simple and hassle-free.

Another option is to open a solo 401(k) as a self-directed IRA. A self-directed IRA is legally no different from any other IRA, but it allows more flexibility by allowing the account holder to invest in alternative assets (e.g., real estate, promissory notes, and private placements), which many off-the-shelf providers do not allow. As with the solo 401(k), the account holder is responsible for performing due diligence on the investment opportunity and its sponsor to ensure it is a sound investment. For those interested in alternative assets and who may not qualify for a solo 401(k), self-directed IRAs do put the control back in the hands of the investor too.

The earlier you start saving for your retirement, the better the chance there is to achieve your retirement goals. A solo 401(k) can be a great tool for investing in your retirement. It’s important for you to do the research to make sure this plan is right for you and you are prepared to handle the management and administration required. Always adhere to the rules for a solo 401(k), and always seek expert advice when something is in question.

Custodians like Quest are educated to provide most answers to solo 401(k) questions. If you are interested in learning more about how to invest with a solo 401(k) with the latest online platforms or to simply understand if this account is right for you, call a knowledgeable custodian like Quest Trust Company to learn everything you need to know to start taking control!

Tags | IRA | IRAs | Retirement
  • Derreck Long

    Derreck Long, Senior Wealth Manager at Eckard Enterprises, first served in the military from 2010 to 2014. After leaving the military, he went to college at Northern Arizona University and received a degree in global marketing. After graduating college Derreck worked with the FBI, but realized there is more to life, and started searching on how to become an investor. This is when Derreck started experimenting in notes, and has been a private lender ever since. Derreck has done a large range of notes from equity appreciation, 2nd lien notes, to the traditional 1st lien and Mineral Rights in the oil and gas space. As of today, Derreck works with Eckard Enterprises, and on a government relations committee where he researches tax code and new bill/law changes at the congress level.

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