What Is a Solo 401(k)?
A solo 401(k) plan, sometimes called a one-participant 401(k), is a traditional 401(k) plan for a business owner or partners with no employees, or for the owners and their spouses. Solo 401(k) plans follow the same rules as other 401(k) plans.
Basics of Solo 401(k) Plans
A solo 401(k) is a 401(k) retirement plan designed specifically for small business owners who have no employees. If your business has even one employee, you do not qualify for a solo 401(k) plan. But you can cover yourself and your spouse with a solo 401(k).
- One-participant 401(k)
- One-participant k
The rules governing solo 401(k) plans are just like those governing traditional 401(k), Roth 401(k), and other 401(k) plans. There are annual contribution limits, early withdrawal penalties and the ability to make catch-up contributions.
- SEP 401(k) plan
- Traditional IRA
- Roth IRA
Solo 401(k) plans also allow business owners with no employees to take advantage of 401(k) tax breaks while saving for retirement.
Solo 401(k) Tax Advantages
A solo 401(k) can be set up as a traditional 401(k) or a Roth 401(k) to take advantage of each type’s unique tax advantages.
- Traditional Solo 401(k)
- Contributions you make to the plan are pre-tax. This means you pay no income tax on the money you contribute while lowering your taxable income. But you will pay taxes on the money you withdraw from the plan once you retire.
- Roth Solo 401(k)
- Contributions you make to your plan are after-tax contributions. This means you pay income tax on the money you contribute into your plan. But you will pay no taxes on the money you withdraw from your solo 401(k) plan when you retire.
In addition, as your own employer, you’re allowed to contribute an employer-matching contribution into the plan. This money is tax-deductible up to the IRS’s employer contribution limits.
How to Set Up a Solo 401(k)
You can open a solo 401(k) plan through various financial institutions including online brokerage firms, investment firms or insurance companies that offer them.
Before you set up a solo 401(k), the Internal Revenue Service requires that you have a written plan declaring which type of plan — a traditional 401(k) or a Roth 401(k) — you intend to use. This written plan may be an IRS-approved form provided by the institution where you set up your solo 401(k) plan.
You then need to create a trust — an agreement with the institution to hold title to the assets in the 401(k) plan to protect your investment and oversee distributions and withdrawals.
There are no age or income restrictions for setting up a solo 401(k) plan, but you must be a business owner with no employees.
Solo 401(k) Contribution Limits and Early Withdrawal Penalties
The IRS limits how much you are allowed to contribute each year to a solo 401(k) plan, but the tax code allows the business owner to be employer and employee under 401(k) rules.
That means you can make an employee contribution and an employer contribution to the plan. You can also make both types of contributions on behalf of your spouse.
You can also cover your spouse with your solo 401(k) plan, effectively doubling the potential contributions to the plan each year.
In addition to making employee contributions for your spouse, you can also make an employer matching contribution up to IRS limits, according to the Pension Research Council at the University of Pennsylvania.
You can also make catch-up contributions — additional contributions as you near retirement age — once you turn 50.
- Employee Contributions
- You can contribute up to $19,500 in 2020. This includes up to 100 percent of your earned income for the year up to that limit.
- Catch-up Contributions
- You can contribute up to an additional $6,500 in 2020 if you are age 50 or older.
- Employer Contributions
- You can contribute up to 25 percent of income from your business as defined by your plan if you are a limited liability business owner. If you are self-employed, you can calculate your employer contribution limit using the rate table or worksheets in Chapter 5 of IRS Publication 560.
Total contributions, not counting catch up contributions, can’t exceed $57,000 per person — you and your spouse, if covered — for 2020.
If you are a business owner who has a 401(k) through a second job, you are still limited to $57,000 spread across both plans. The limit is per person, not per plan.
Early Withdrawal Penalties
There is typically a penalty if you withdraw money from a solo 401(k) prior to six months after your 59th birthday. The penalty is 10 percent of your withdrawal. You will also have to pay income taxes on the money you take out.
There are a few exceptions that will allow you to withdraw money without having to pay the penalty, but you will still have to pay taxes on the money you withdraw.
- Termination of the solo 401(k) plan
- You suffer a hardship or other “triggering event” defined in your plan
- You make excessive contributions causing the money to be returned to you
- Death or disablement
The CARES Act of 2020 also eliminated the 10 percent penalty on COVID-19 related withdrawals if they were made for hardships directly related to the pandemic.
- You, your spouse or a dependent was diagnosed with COVID-19 with a CDC-approved test, or
- You suffered financial problems as a result of COVID-19 related events including loss of a job or job offer, reduction in pay or self-employment income, quarantine, forced closure of your business, lack of childcare or other factors allowed by the U.S. Treasury Department.
One-third of the money you take out will be taxed as income each year, spread out over three years, but you will not have to pay the additional penalty. The act also allows you to increase your contributions beyond the limits to pay back the money you withdraw if you’re able to do so.
7 Cited Research Articles
- Ortiz, H. and Scheithe, E. (2020, June 30). Considering an Early Retirement Withdrawal? CARES Act Rules and What You Should Know. Retrieved from https://www.consumerfinance.gov/about-us/blog/cares-act-early-retirement-withdrawal/
- U.S. Internal Revenue Service. (2020). Guidance for Coronavirus Distributions and Loans from Retirement Plans Under the Cares Act. Retrieved from https://www.irs.gov/pub/irs-drop/n-20-50.pdf
- U.S. Internal Revenue Service. (2019, December 4). One-Participant 401(k) Plans. Retrieved from https://www.irs.gov/retirement-plans/one-participant-401k-plans
- U.S. Department of Labor. (2019, November). 401(k) Plans for Small Businesses. Retrieved from https://www.dol.gov/sites/dolgov/files/ebsa/about-ebsa/our-activities/resource-center/publications/401k-plans-for-small-businesses.pdf
- Fisher, P. (2019, January 25). Captain Your Own Ship: Retirement Security Options for the Self-Employed. Retrieved from https://pensionresearchcouncil.wharton.upenn.edu/blog/captain-your-own-ship-retirement-security-options-for-the-self-employed/
- U.S. Securities and Exchange Commission. (n.d.). Traditional and Roth 401(k) Plans. Retrieved from https://www.investor.gov/additional-resources/retirement-toolkit/employer-sponsored-plans/traditional-and-roth-401k-plans
- Northeastern University, D’Amore-McKim School of Business. (n.d.). How Business Owners and Self-Employed Workers Can Save for Retirement. Retrieved from https://onlinebusiness.northeastern.edu/blog/how-business-owners-and-self-employed-workers-can-save-for-retirement/