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The perks of self-employment are plenty, but there’s at least one significant drawback: the lack of an employer-sponsored retirement plan like a 401(k). Enter the solo 401(k), or what the IRS calls a one-participant 401(k). Designed for self-employed workers, a solo 401(k) mimics many of the features of an employer-sponsored plan, without the drag of working for the man.
A solo 401(k) is an individual 401(k) designed for a business owner with no employees. In fact, IRS rules say you can’t contribute to a solo 401(k) if you have full-time employees, though you can use the plan to cover both you and your spouse.
Just want the need-to-know basics about this retirement account? Here’s the breakdown:
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For more detailed information, read on.
The total solo 401(k) contribution limit is up to $57,000 in 2020 and $58,000 in 2021. There is a catch-up contribution of an extra $6,500 for those 50 or older.
To understand solo 401(k) contribution rules, you want to think of yourself as two people: an employer (of yourself) and an employee (yes, also of yourself). Within that overall $57,000 contribution limit in 2020, your contributions are subject to additional limits in each role:
Keep in mind that if you’re side-gigging, employee 401(k) limits apply by person, rather than by plan. That means if you’re also participating in a at your day job, the limit applies to contributions across all plans, not each individual plan.
The nice thing about a solo 401(k) is you get to pick your tax advantage: You can opt for the traditional 401(k), under which contributions reduce your income in the year they are made. In that case, distributions in retirement will be taxed as ordinary income. The alternative is the Roth solo 401(k), which offers no initial tax break but allows you to take distributions in retirement tax-free.
In general, a Roth is a better option if you expect your income to be higher in retirement. If you think your income will go down in retirement, opt for the tax break today with a traditional 401(k).
Because of these tax perks, the IRS has pretty strict rules about when you can tap the money you put into either type of account: With few exceptions, you’ll pay taxes and penalties on any distributions before age 59 ½.
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The IRS allows one exception to the no-employees rule on the solo 401(k): your spouse, if he or she earns income from your business.
That could effectively double the amount you can contribute as a family, depending on your income. Your spouse would make elective deferrals as your employee, up to the $19,500 employee contribution limit (plus the 50-and-older catch-up provision, if applicable). As the employer, you can then make the plan’s profit-sharing contribution for your spouse, of up to 25% of compensation.
You can open a solo 401(k) at most online brokers, though you’ll need an . The broker will provide a plan adoption agreement for you to complete, as well as an account application. Once you’ve done that, you can set up contributions. You’ll have access to many of the investments offered by your broker, including mutual funds, index funds, exchange-traded funds, individual stocks and bonds.
If you want to make a contribution for this year, you must establish the plan by Dec. 31 and make your employee contribution by the end of the calendar year. You can typically make employer profit-sharing contributions until your tax-filing deadline for the tax year.
Note that once the plan gets rocking, it may require some additional paperwork — the IRS requires an annual report on Form 5500-SF if your 401(k) plan has $250,000 or more in assets at the end of a given year.
If you need help managing the funds in your solo 401(K), robo-advisor Blooom will manage your 401(k) at your existing provider. If you want even more comprehensive financial help, you might opt for an online planning service. Companies such as Facet Wealth and Personal Capital offer low-cost access to human advisors and provide holistic guidance on your finances, including how to invest your 401(k).
Here are more resources to help you weigh your options as a self-employed worker: