What is a Solo 401(k) Plan?

The self directed 401k is a great retirement strategy if you’re a sole proprietor. Here’s a look at what is a solo 401k plan.

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Self-employed workers who want to save for retirement may be interested in a solo 401(k) plan. Also known as a self-directed 401(k), the solo 401(k) lets you set aside more money each year than you would with an IRA (another retirement savings option for self-employed workers).

You can contribute to a solo 401(k) if you have no employees, with the exception of your spouse who can also contribute to the plan if he or she earns money from your business. You can even contribute to a individual 401(k) if you have a part-time business of which you are the sole proprietor. However, your maximum contributions are limited based on contributions to your employer’s plan and come with some 401k retirement plan rules.

Contributions to a Solo 401(k)

Since self-employed workers are both the employee and employer in their business, they have two 401k contribution limits. First, you’re able to contribute up to $16,500 as an employee of your company, or $22,000 if you’re over age 50. As your own employer, you can make an additional profit-sharing contribution that’s up to 25% of the business net-income. The annual profit-sharing is $49,000.

Like many other retirement plans, a benefit of the solo 401k plan is that you can make tax-deferred contributions to the plan. You don’t pay taxes on the money you contribute to your plan until you withdraw it at retirement.

You can also split your contributions so that some are made into a Roth solo 401(k) and others are in a traditional solo 401(k). For example, you can set up your plan so that your employee contributions are made in a Roth-style, meaning they’re contributed post-tax and not taxed at withdrawal. Your employer contributions are always tax-deferred. One of the benefits of contributing to a Roth 401k plan is that you take advantage of today’s tax rates because tax rates could be higher when you retire.

Contribution amounts aren’t fixed and you can contribute a different amount each year. You can contribute more money during years that your business earns more money and less in the years your business earns less. Spouse contributions are made in addition to
yours, i.e. the two of you could contribute up to $98,000 considering the profit-sharing contribution maximum.

You can invest your contributions in a number of assets including stocks, bonds, and cash depending on your risk tolerance.

Comparing To Contribution Limits of Other Plans

The 401k contribution limits for a solo 401(k) are much higher than other retirement plans available for self-employed workers. The SIMPLE IRA rules have a maximum limit of $11,500 or $14,000 if you’re over age 50. The traditional and Roth IRA contribution limit is $5,000 or $6,000 for those over 50. Roth IRAs have income limits that may reduce or eliminate your ability to contribute. An SEP IRA limits contributes to 25% of employee compensation.

Withdrawing From Your Plan

If you withdraw money from your solo 401(k) before you reach retirement age of 59 ½, you face early 401k withdrawal penalty of 10% and you’ll have to pay tax on the amount you withdraw. (You’ll pay taxes regardless of when you withdraw the money unless you’re withdrawing from a Roth solo 401(k).) You may be able to avoid the penalty if you’re withdrawing money to buy your first home, to cover expenses from a disability, or to cover high education expenses. You can borrow half of your solo 401(k) balance up to $50,000 instead of taking a withdrawal.

Drawbacks of an Individual 401(k) Plan

Individual 401(k) plans can require more paperwork than other types of plans. Even if you’re prepared to deal with the extra paperwork, you have to decide if you want to pay the setup and annual account fees associated with solo 401(k) plans. You can expect fees to range from $10 to $400 depending on which financial institution you choose. Companies that offer these self directed 401(k) plans include Vanguard, T. Row Price, Fidelity, and ShareBuilder.