Solo 401(k)s: Do you qualify for a self-employed 401(k)?

Are you a self-employed professional planning for your retirement? A self-employed 401(k), popularly known as a solo 401(k) and referred to by the IRS as a one-participant 401(k), is an excellent way to build up your retirement nest egg. Whether you are a freelancer, shop owner, or small business owner without employees, a solo 401(k) retirement plan can help you retire comfortably.

While there are various options to save for retirement, freelancers and sole proprietors should consider if a solo 401(k) plan best meets their retirement saving goals. Generally, self-employed individuals—including consultants, freelancers, and other independent contractors—benefit from solo 401(k) plans because of their high contribution limits.

Below is an overview of the solo 401(k), including how to set one up, how to withdraw from a solo 401(k), and other vital information.

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Who qualifies for self-employed 401(k)s

A self-employed 401(k), also called individual 401(k) or solo 401(k), is a retirement savings plan for sole proprietors, independent contractors, and other small business owners who have no employees or only employ their spouse. 

For the purposes of a solo 401(k), “small business” can mean a sole proprietorship, a limited liability company, a limited partnership, a S corporation, or a C corporation. Solo 401(k)s provide a retirement option similar to what large employers provide for their employees.

How does a solo 401(k) work?

As the IRS points out, solo 401(k) plans aren’t a new type of 401(k) plan, but instead, a traditional 401(k) with the same rules and requirements as any other plan. The main difference is that the business owner wears two hats—both the employee and the employer—and contributions can be made in both capacities. Not only does the solo 401(k) have a higher contribution limit than an IRA, they also allow the account owner’s spouse to contribute to the same plan, if they receive compensation from the employer.

A solo 401(k) plan also offers tax breaks if you are eligible. You can deduct the contributions from your income if you did not incorporate the business. If you run a corporation, you can classify the contributions as a business expense.

Solo 401(k) plans have no annual minimum contribution requirements. That means that you can make the maximum contributions and then reduce your savings during periods with lower cash flow. However, once a 401(k) has at least $250,000 in the account, you must file IRS Form 5500-EZ annually to report the financial status of your solo retirement plan to the IRS and Department of Labor.

Pros and cons of solo 401(k) plans

Solo 401(k) Roth deferral options

Solo 401(k) plans may also allow participants to contribute Roth deferrals. Unlike pretax deferrals, where a participant would pay taxes on contributions at the point of withdrawal, Roth contributions are made on an after-tax basis. 

This may be an attractive option for sole proprietors currently in pre-startup mode that may be making the least amount of money and in the lowest tax bracket. These individuals could benefit from a solo 401(k) with Roth contributions because they’ll take the tax hit at their current lower rate. Then, all monies in the nest egg grow tax free and all Roth qualified distributions, including any investment gains, are exempt from any income taxes.

To learn more about 401(k)s with Roth deferrals, read: Types of 401(k) plans

Roth IRA vs 401(k) Roth contributions for high earners

A common vehicle for individuals saving for retirement, the Roth IRA is similar to the solo 401(k) that allows Roth contributions in that they both use after-tax dollars, meaning that the account owner doesn’t have to pay income taxes when they receive distributions. Beyond the shared name, a key distinction between Roth IRA and a 401(k) that allows Roth contributions is that the latter does not have an income limit. 

As established by the IRS, individuals with an adjusted gross income (AGI) of more than $161,000 in 2024—or married couples filing jointly with an AGI of $240,000—aren’t eligible for Roth IRA contributions. Solo 401(k) plans that allow Roth contributions do not have income limits. Combine that with higher contribution limits compared to Roth IRAs,  401(k)s with a Roth feature can be attractive for high earners.

What are the contribution limits for a solo 401(k)?

If you're a business owner without any common-law employees, you're wearing two hats: the employee and the employer. Here's what that means for your contributions in the 2023 tax year:

• Elective Deferrals: Think of this as your personal contribution. You can stash away up to 100% of your earnings, but there's a cap at $23,000. Over 50? You get a bit of a bonus, pushing your limit to $30,500.

• Employer Contributions: This is where your 'employer hat' comes in. You can chip in an additional 25% of your compensation on behalf of your business.

It’s important to remember that when you combine both contributions, make sure you don't cross the $69,000 mark in 2024. And if you're juggling multiple jobs with 401(k) plans, remember the limit on elective deferrals applies to you as a whole, not per plan.

For the self-employed, there's a bit of math involved to figure out your max contribution. And if your solo 401(k) assets grow beyond $250,000 by year-end you’ll need to file Form 5500-EZ.

Self-employed compensation for a solo 401(k)

Self-employed individuals are required by the IRS to use a particular formula to determine their compensation, on which the maximum amount of employer contributions is based on. When figuring the contribution, compensation is your “earned income,” which is defined as net earnings from self-employment after deducting both:

• One-half of your self-employment tax

• Employer contributions for yourself.

For more details and links to worksheets and rate tables, refer to the IRS’s Calculating Your Own Retirement Plan Contribution for self-employed individuals.

Solo 401(k) with spouse

The one-employee rule of a solo 401(k) doesn’t include the spouse of the business owner. When a spouse derives income from the sole proprietorship, they’re allowed to make contributions to the Solo 401(k) plan as well. Spouses can contribute 100% of their compensation, up to $23,000 as an employee (plus the catch-up provision if 50+). If the business owner contributes employer contributions to the plan, they also must contribute the same percentage of employer contribution they made for themselves (up to 25% of total compensation) to their spouse.

This means a married couple with a solo 401(k) can receive benefits totaling up to $132,000 ($147,000 when both are age 50 and over) every year. 

Filing requirements for a solo(k)

Once the plan reaches $250,000 in retirement funds, the employer is required to submit a Form 5500-EZ reporting the plan’s financial status. 

Solo 401(k) or a SEP IRA?

Both solo 401(k)s and SEP IRAs are available to small business owners and self-employed individuals and both have higher contribution limits than traditional 401(k)s and IRAs. A SEP IRA, or Simplified Employee Pension plan, works like a traditional IRA in that contributions grow tax-free and may be deducted from taxable income, and tax is paid only on withdrawals. You can contribute up to $69,000 for 2024 ($66,000 for 2023; $61,000 for 2022) to a SEP IRA, provided your contributions do not exceed 25% of your pay.

So, what are the differences between a solo 401(k) and a SEP IRA? Each offers some flexibility that the other doesn’t. A SEP IRA is an option for any size business, but a solo 401(k) is available only to those business owners with no employees other than a spouse. However, a solo 401(k) plan allows for catch-up contributions starting at age 50. A SEP IRA doesn’t. There are some other differences as well. Read more about solo 401(k)s compared to SEP IRAs.

Solo 401(k) deadlines

If you’re a full-time freelancer, it can be tempting to wait to open a solo 401(k) until you receive payment from bigger clients. However, with a solo 401(k), the sooner may be better. The good news is that you still have until the following year’s tax filing deadline (typically mid-April) or later, if you request and receive an extension, to contribute to your retirement account for the previous year.

Fees for solo 401(k)

A self-employed 401(k) plan is the same as an employer-sponsored plan, so you can generally expect similar pricing and fees. However, it’s important to consider the size of your business against larger plans when calculating fees. 

Asset fees are the cost of managing the investments in your plan, and are usually charged as a percentage against your assets under management (AUM). Plans with 25 employees and up to $250,000 in total assets usually have asset fees of roughly 1.60%. At Human Interest, a monthly investment advisory fee of up to 0.01% of the plan's assets is charged to the plan and allocated to participants' account. In addition, participants using Human Interest Advisors' Model Portfolios tend to see average fund expense ratios of 0.07%.¹ While some companies may charge a higher AUM fee based on the number of employees in the plan, we don't do that at Human Interest.

Solo plans can expect administrative fees associated with the day-to-day plan operations, such as recordkeeping, customer support, and accounting. Finally, many providers charge service fees for specific plan features—and in the case of a solo plan, these costs would be transferred to you. Examples of these service fees include distribution fees, plan termination fees, and loan initiation fees. Human Interest does not charge additional service fees, which could save you money as you scale your business

What are some rules and regulations on solo 401(k) plans in 2024?

The self-employed 401(k) plans have several regulations designed to help you contribute towards retirement. Here are the main solo 401(k) rules:

• If you withdraw from the account before age 59½, you may pay a 10% early withdrawal penalty and applicable income taxes.

• Once you reach age 73, in accordance with the SECURE Act 2.0, you must take Required Minimum Distributions (RMD). 

• You may structure the plan to fund loans and hardship distributions.

• You may rollover  savings from another compatible 401(k) plan or an IRA account into a self-employed 401(k).

• If your business adds employees later, you must either convert the solo 401(k) to a standard 401(k) or close the plan.  

A solo 401(k) plan may be ideal if you want to set up a retirement plan as a self-employed person. Among employer-provided plans, it has the highest contribution limits, which allows you to contribute more to your retirement savings —and you can also take advantage of 401(k) tax benefits.

How do you set up a self-employed 401(k)?

It can be easy to set up a solo 401(k) plan with a 401(k) administrator, like Human Interest. Many administrators allow you to open a self-employed 401(k) online. To set one up, you will need an Employer Identification Number (EIN), which you can get from the IRS. You’ll also need to complete an account application and a plan adoption agreement, in which you’ll choose some of the plan’s provisions. Self-employed 401(k)s are typically easy to administer; these plans should offer low maintenance fees because they involve only one or two people. 

Before choosing a plan administrator and signing up, it’s important to compare administrator fees. You may also want to choose an administrator that allows you to invest your retirement savings into a broad range of assets, including mutual funds, ETFs, CDs, stocks, and bonds. Other features to look for include 24-hour multi-channel support, investment advisory services, low fees, and positive customer reviews. 

Once you’ve completed the paperwork, and the plan becomes active, the only thing you have to do is to set annual contribution levels, choose your risk tolerance and investment path.

Solo 401(k) alternatives for self-employed individuals

If you're self-employed and exploring retirement options beyond the solo 401(k), you have some solid choices. The SEP IRA is straightforward, letting employers easily contribute to their own and their employees' retirement.

The SIMPLE IRA is tailored for small businesses, employee contributions are allowed and employer contributions are required. Then there's the Traditional or Roth IRA which offers tax perks, though they come with lower contribution caps.

1 - An investment advisory fee is paid to Human Interest Advisors (HIA) of 0.01% of plan assets and a separate fee for recordkeeping services and custody-related expenses is paid to Human Interest Inc. (HII) of 0.05% of plan assets. Both fees are deducted on a monthly basis from the employee's account according to the HII and HIA Terms of Service. All prices are exclusive of applicable taxes. If the plan sponsor elects to hire an external investment advisor, the plan sponsor will pay such advisor as agreed between the plan sponsor and advisor. For more information, please see our pricing page.

Average fund fees as of 3/31/24. Asset-weighted average of mutual fund annual operating expenses ("expense ratio") for all plan participants invested in Human Interest Advisors' Model Portfolios ("Models"). Provided for illustrative purposes only. Actual, average fund expenses a participant experiences vary based on the specific Model selected, allocation changes to Models, whether participants opt out of Models and choose their own investments and allocations, or allocation drift, especially in volatile markets. Model allocations and underlying mutual fund expenses are subject to change. Before investing, carefully review the fund’s prospectus, which includes, among other things, a description of fees and expenses a fund will charge.