There’s a lot to love about being your own boss. But, there is one huge drawback; not having an employer-sponsored retirement plan. Here are the rules for solo 401 k’s and the contribution limits in 2021.
An employer-sponsored retirement plan might not have been something that you thought about previously. However, it’s essential if you want to enjoy your golden years. I mean, you worked your tail off, so you deserve it!
Thankfully, the self-employed do have retirement plan options, like a SEP IRA. But, there’s also the solo 401(k) that you should consider.
What Is a Solo 401(k)?
As you might have surmised, a solo 401(k) is a retirement plan designed, well, for individuals. Specifically, business owners who only employee me, myself, and I. Sole proprietors, independent contractors, and freelancers all quality — just as long as they don’t employ anyone else. And, don’t try to pull a quick one on the IRS as they are very strict about this requirement.
However, there are a couple of caveats. One is that if you’re married. If so, your spouse is also covered.
The second is that if you’re earning money from a side hustle, but just so happen to have a full-time job as well. You may be able to contribute to both. However, to play it safe, double-check with a tax professional.
And, in case you’re curious, there are no age or income restrictions when it comes to a solo 401(k).
Still interested? Awesome because when it comes to a solo 401(k) retirement plan, you typically have two options.
The first is a traditional 401(k). As Troy Segal explains for Investopedia explains, with this plan, “you invest your dollars pre-tax, effectively claiming a tax break during your working years.” That means that when you retire, “you pay income taxes on the funds you withdraw—including the money your investments have earned over the years.”
”The downside is that when you are ready to withdraw your money, the tax rate could be higher than when you initially invested. The additional tax burden might erase any tax benefits received previously,” adds Segal. “Keep in mind, though, that most retirees are in a lower tax bracket than they were during their working years.”
Your other option is the Roth 401(k). Because these are funded with after-tax dollars, you’ve forked over your hard-earned cash to the IRS. That also means that withdraws are also free. “That’s totally tax-free, both the amount you paid in and the returns the account earned,” adds Segal.
Another consideration with a Roth 401(k) is that your paychecks won’t be as much because you are paying taxes now. That might be an issue if you’re barely holding your head above water.
Solo 401(k) vs. SEP IRA
Just because you’re self-employed doesn’t mean that a solo 401(k) is your only retirement option. Like in real estate, you could make investments or play it a little safer with a Simplified Employee Pension.
Known as SEP IRA’s, this retirement savings plan for the self-employed allows you to contribute up to 25% of your net earnings, clarifies Kayla Sloan in a previous Due article.
“The money you invest is pre-tax,” she adds. “If you want to set up, fill out an IRS form 5305-SEP Simplified Employee Pension-Individual Retirement Account Contribution Agreement.”
“Setting up a SEP IRA can be done just before you file your taxes,” Kayla states. “This allows you to adjust your contribution if your taxes are high that year.” And, as a result, “this allows you to lower what you would owe Uncle Sam.”
There is, unfortunately, a drawback. And, that is that “the largest amount the IRS will allow you to contribute is $54,000,” adds Kayla. “Additionally, if you employ others, you must set up SEP IRAs for them also under certain conditions. To ensure you do it properly, go over the requirements thoroughly before you decide to invest in this manner.”
Another key difference between a solo 401(k) or a SEP IRA is that catch-contributions are not allowed. The reason is that it’s funded via employee contributions. So, if you’re getting a late start on your savings, you might want to consider this.
Tax Advantages of the Solo 401(k)
If you’re ready to roll with a solo 401(k), then probably made the right decision. I mean, how many other retirement plans like you pick your tax advantage.
Your eyes didn’t deceive you. Arguably, this is probably the best advantage. For example, let’s say that you chose the traditional 401(k). Since contributions reduce your income in the year you made them, distributions will be taxed as ordinary income when enjoying your retirement.
What about the Roth solo 401(k)? In case it is already slipped your mind, there are no initial tax breaks. However, when it comes to distributions in retirement that are tax-free. I
As a general rule of thumb, if you expect your income to be higher in retirement, that Roth is your better option. What if your income will decrease in retirement? Then take that tax break today — which means you have to go with a traditional 401(k).
Keep in mind that because of these tax advantages, the IRS has strict rules in place. Mainly when it comes to making withdraws. At the forefront, the taxes and penalties you’ll be hit with on distributions before age 59 ½.
“In a traditional 401(k), you can start receiving distributions at age 59 ½,” clarifies financial expert Chris Hogan. “With a Roth 401(k), you can start withdrawing money without penalty at the same age, but you also must have held the account for five years.”
“If you’re still decades away from retirement, you don’t have anything to worry about!” adds Hogan. “But if you’re approaching the 59 1/2 year mark and thinking about starting a Roth 401(k), it’s important to be aware that you won’t have access to the money for five years.”
Solo 401(k) Contribution Limits
Now, it’s the moment you’ve all been patiently waiting for; what are the contribution limits with a solo 401(k)?
Well, limits are actually a combination of three factors.
- Salary deferral contributions. These are the contributions that you made from your salary.
- Catch-up contributions. If you’re over 50, then this would be any additional money you put into the plan.
- Employer contributions. There are the funds that your company contributed to the plan.
“There are two types of limits,” explains Dana Anspach in The Balance. “A limit on the maximum amount you can contribute as a salary deferral and a limit on the number of total contributions, which includes both your and your employer’s contributions.”
Thanks to a rise in inflation, the IRS usually increases “the salary deferral contribution limit by $500” every year. So, in 2019, you could contribute up to $19,000 of your wages. But, for 2020, that jumped up to $19,500.
“For those ages 50 and older, the catch-up contribution is capped at $6,500, for an annual total of $26,000,” states Anspach.
What about the maximums?
In 2020, the total contribution limits rose by $1,000 with the maximums being:
- $57,000 total annual 401(k) contribution limit if you are age 49 or younger
- $63,500 total annual 401(k) contribution limit if you are age 50 or older
“The dollar amounts listed above represent the total maximum amount that can be contributed as a combination of both your own and your employer’s contributions,” Anspach adds.
“In addition to these allowable contribution amounts, you can sometimes contribute additional amounts to other types of plans, like a 457 plan, a Roth IRA, or a traditional IRA,” she says. “It all depends on your income and the types of plans available to you.”
It’s expected to remain the same for 2021. But, keep tabs on updates from the IRS or work with a tax professional who is up-to-speed.
Solo 401(k) Withdrawal Rules
We briefly went over this, but let’s dig a little deeper.
For starters, because this savings plan is meant for your retirement, it’s not easy making withdraws. With just a few exceptions, like medical expenses, you’ll probably face a 10% penalty tax if withdrawing from a traditional Solo 401(k) account that was made before you turned 59 ½. You should also expect to add income taxes on the amount withdrawn as well.
That penalty does not apply to a Solo Roth 401(k). But, you must pay the penalty and income tax on earnings. What’s more, you’re not permitted to withdraw only from this plan.
For 2020 specifically, the CARES Act will temporarily let eligible 401(k) participants who are younger than 59 ½ take an early distribution. How much? Up to $100,000. And, they won’t have to pay the 10% tax penalty either.
You also could take out a solo 401(k) participant loan out, which must be paid back within 5 years, Or you could roll it over to a Roth IRA, Traditional IRA, Simple IRA, SEP-IRA, 457(b), 403(b) or another qualified plan.
How to Open a Solo 401(k)
Opening up a solo 401(k) isn’t all that difficult. In fact, most online investment brokers will hook you up. You will need an employer identification number. If you don’t have that, you can snag one from the IRS.
Got your EIN handy and additional paperwork like an annual report on Form 5500-SF? Great, now you need to fill out the application and set up your contributions. You can roll over money from other accounts or set up automatic transfers from a checking or savings account to get started.
The Bottom Line
For those flying solo, this retirement plan should be on your radar. It has higher contribution limits than most other plans. There’s also the Roth option, and you can play catch-up with the age 50 provision. And, it’s pretty easy to open and fund.
Of course, make sure to talk this over with a financial advisor to ensure that the solo 401(k) plan is right for you. But, we think it’s a solid choice for sole proprietors.