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Solo 401(k): Tips on finding a provider, adding your spouse, and fees

11 MIN READEditorial Policy

America is truly the land of entrepreneurship. Nearly one in every three Americans (close to 54 million!) is an independent worker or freelancer. While getting established can often be challenging, freelancers that make it are able to make a decent living. For example, in May 2015 the median annual wages for freelance writers and authors ranged from $57,640 to $64,380 across top industries.

Whether you’re a novice or trail-tested independent worker, you can take advantage of a solo 401(k) (also known by many other names: solo-k, uni-k, one-participant k, self-employed k, independent k, independent 401(k), or indie k) to save up large sums for retirement and minimize your tax bill even further. Not convinced? We recommend reading 401(k) Tax Advantages to start.

To make the most out of your solo 401(k), let’s review a few good strategies when managing a solo 401(k).

Are you actually “solo”?

One main consideration for a Solo 401(k) is obviously your solo status. If you’re currently a sole proprietor and don’t see yourself expanding your business siginificantly, then a Solo 401(k) is for you and you should definitely read the rest of this article. If you do see yourself hiring several employees in the short- and long-term, then you’re better off looking for a regular 401(k), preferably one designed for small businesses. We’d recommend this article if that is indeed the case: 401(k) Basics for Employers.

One exception: If you’d like to include your husband, wife, or partner on your Solo 401(k), that’s possible — more on that below, in the last section.

Take note of the deadlines to set up and contribute to a Solo 401(k)

Some freelancers may procrastinate on opening their solo 401(k) plans until they receive payment from their bigger clients. With a solo 401(k), the sooner is indeed better. While you can open an independent 401(k) at any time, you have until December 31, 2016 to make it count for tax year 2016.

The good news is that you would still have until next year’s Tax Day (typically April 15) to contribute to your retirement account. So, you can use the monies from those late-paying customers to make up for smaller contributions throughout the previous year and reduce your taxable income.

Balance between low fees and available investment options and services

As with anything else in business, cheaper is generally better. In an effort to attract more customers, many mutual-fund, brokerage, and discount-brokerage firms offer solo 401(k) plans with no setup fees or low annual investment fees. However, make sure that you understand what you get into before you set up that retirement account.

With setups fees ranging from zero up to a couple hundred dollars and annual fees ranging between 1% to 2% of total assets, a very low fee may mean that you receive the bare minimum service. This often means no financial advice, limited investment options, and lack of other features that are common in an employer-sponsored 401(k) with a full-service retirement group. One example of such missing features is the ability to take out a loan from a 401(k).

Also, keep in mind that additional fees can be triggered by certain milestones, such as the filing of annual report on Form 5500-SF once your assets reach $250,000 or more. (With a solo 401(k), such a high account balance can happen sooner than you think! More on this later on.)

Take advantage of automatic rebalancing to optimize your investments

For individuals just starting out to build their nest egg, having little time available (freelancers are a one-man-or-woman operation, after all!), or lacking investment knowledge, automatic portfolio rebalancing can be a critical feature to look for in a one-participant plan.

The reality is that most individuals don’t really know how to choose their own investments and make big mistakes that cost them hundreds of thousands of dollars in investment gains over the lifetime of their retirement accounts. Even the full-time professional investors have a hard time making trades: only 20% to 35% actively managed funds beat the benchmark for their category.

To find out more reasons dragging down 401(k) investment returns, read: Your 401(k) is Underperforming the Market: What Should You Do?

To make the best out of your contributions, consider a more full-suite solo 401(k) provider that offers the feature to rebalance your portfolio automatically based on time-tested investment theories, including modern portfolio theory, efficient market theory, and the capital asset pricing model, espoused by the world’s leading financial economists. Knowing that your portfolio is following best practices of investing without extra research or work on your part can provide you peace of mind so that you can focus on running your business.

Don’t forget to take a look at Roth Solo 401(k)s

Just like with regular 401(k) plans, solo 401(k)s offer the option to contribute with pre-tax or post-tax dollars. Contributing to a traditional solo 401(k) makes the most sense when you expect to be in much lower tax bracket at retirement age than today.

Freelancers who are starting out or sole proprietors in pre-startup mode know that right now is the time when they’ll make the least amount of money. So, these individuals could benefit from a solo Roth 401(k) and take the tax hit at the current lower rate. Then, all monies in the nest egg grow tax free and all qualified distributions, including any investment gains, are exempt of any income taxes.

To learn more about Roth 401(k)s, read: Roth vs. Traditional 401(k)s: Differences, Similarities, and Investment Criteria

Make up for previous small contributions to other retirement accounts

An independent 401(k) enables you to make up for a string of low contributions years to your retirement account or, even worse, absolute lack of historical contributions. In 2021, here’s a comparison of the maximum employee contribution limits for several qualified plans:

Types of PlansAnnual Contribution LimitAnnual Contribution Limit Age 50 and Over
Traditional and Roth 401(k)$18,500$24,500
Traditional and Roth IRA$5,000$6,000
Simple IRA$12,500$15,500
Solo and Roth 401(k)$53,000$59,000

While a 401(k) or IRA do offer the option for employer matches, the solo 401(k) is the only option that doesn’t require a minimum period of holding or contributing to account. In a traditional or Roth solo 401(k), a freelancer, independent worker, or sole proprietor wears two hats: employee and employer. Since the plan’s inception, you can make contributions to the plan in both capacities.

You can contribute up to $18,500 ($24,500 if you’re age 50 or older) as an employee and you can also contribute 25% of your net self-employment income for the year as an employer. The total annual contribution from both sources can’t be greater than $55,000.

And there’s more!

Team up with your spouse to unlock the full retirement savings potential

The one-employee rule of a solo 401(k) doesn’t apply to the spouse of the business owner. When a spouse derives income from the sole proprietorship, he’s allowed to make contributions equal to those of the business owner. This means a married couple with a solo 401(k) can sock away up to a whopping $106,000 ($109,000 when age 50 and over) every year for retirement. As mentioned earlier, this is how you can reach $250,000 in retirement funds in under three years.

While individuals have many options for saving for retirement, including 401(k) and IRA plans, freelancers and sole proprietors should evaluate whether or not a solo 401(k) meets their retirement saving strategy. Due to the one-employee rule, solo 401(k) plans are best suited for self-employed individuals, including consultants, freelancers and other independent contractors, who don’t plan to add employees other than their spouses.

As these six tips illustrate, when used appropriately, a solo 401(k) can be a powerful tool to jumpstart a nest egg and offset an upcoming large tax bill. Consult your financial adviser or tax accountant to learn more about the solo 401(k) and whether or not it’s a suitable retirement account for your unique financial situation.

If you’re looking for a great 401(k) for your employees, click here to request more information about Human Interest.

Start a 401(k) with Human Interest

A Human Interest 401(k) plan can connect directly with your favorite payroll provider and has zero transaction fees.

Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.

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