How to start a solo 401(k)

Being self-employed doesn’t mean you have to forgo a retirement plan. Although you may not have the option of a big employer-sponsored 401(k) plan, you can opt for a solo 401(k) if you’re a one-person business — and you’ll get the same tax advantages. But it may not be a good fit for all business owners, especially if you plan on growing your business and hiring employees.

The basics of a solo 401(k)

A solo 401(k) plan is an individual retirement account designed for business owners. Here’s what you need to know:

Who qualifies

To be eligible for a solo 401(k), you must be self-employed with no employees except your spouse.

Eligibility requirements

There are no income or age requirements to qualify. Freelancers, independent contractors and small businesses with no qualifying employees (excluding your spouse) generally qualify for a solo 401(k).
The only caveat is that your business should be legit, ongoing and regularly attempt to turn a profit. For example, if your business consistently operates at a loss every year, and you can’t show the intention to generate earned income, the IRS may classify your business as a hobby, which can impact your solo 401(k).

What is a qualifying employee?

The IRS defines a qualifying employee in the following ways:

• A full-time employee working more than 1,000 hours per year
• A part-time employee working at least 500 hours per year for three consecutive years

Contribution limits

With a solo 401(k), you are both the employee and employer.

• Elective deferrals. As an employee, you can invest up to $19,500 per year, with an additional $6,500 in catch-up contributions if you’re 50 or over.
• Employer non-elective contributions. As the employer, you can contribute up to 25% of your earned income.

The total you can contribute towards your solo 401(k) in 2021 is $58,000 ($19,500 as an employee + $38,500 as an employer), along with any applicable catch-up contributions, plus $6,500 for applicable catch-up contributions, which could bring your total to $64,500 if you’re 50 or over.

Tax advantages

Solo 401(k)s can help you save for retirement and come with distinct tax benefits:

• Before retirement. With a traditional 401(k), you invest your money with pretax income, which can reduce your taxable income for the year.
• After retirement. If you opt for a Roth 401(k), your contributions are made with after-tax dollars. That means your withdrawals, which include both your contributions and returns, are tax-free.

Deadline to open one

The deadline to open a solo 401(k) is the same as your business tax return deadline, including deadline extensions. This date depends on your self-employed business entity.

Tax status	Filing deadline	Extended deadline
S-corp	March 15, 2021	September 15, 2021
Partnership	March 15, 2021	September 15, 2021
C-corp	April 15, 2021	October 15, 2021
Sole proprietor	April 15, 2021	October 15, 2021

What to watch out for with solo 401(k)s

Consider the following drawbacks of solo 401(k)s to see if its the right retirement account for you:

• No employer contributions. With employer-sponsored 401(k)s, some employers will match your contribution. But solo 401(k)s don’t have this option for these extra savings — all the money comes directly from your paycheck.
• Continual compliance. To maintain your solo 401(k), you’ll always need to demonstrate profit or the potential to earn income. And you’ll never be able to hire employees, which may impact a growing business.
• Contribution limits. Even if you have a solo 401(k) for a side gig separate from your full-time job, you can’t max out your 401(k) contributions twice.
• High fees. Total plan fees can range anywhere between 0.37% to 1.42%, which can eat into the tax benefits of a 401(k).
• Early withdrawal penalties. Unlike brokerage accounts, a 401(k) plan charges an extra 10% tax if you withdraw before age 59 1/2. The only exception is if you can demonstrate financial hardship.

Is my spouse eligible for a solo 401(k)?

Yes, your spouse can contribute to your solo 401(k) account, even as a full-time W-2 employee in your business. As long as you both receive taxable income, you can both invest in the account.

How to set up a solo 401(k)

Here’s a quick rundown on the steps to open a solo 401(k):

1. Select a provider. Compare plan administrators to find a provider that fits your needs, including fees, investment options and customer experience.
2. Create your plan documents. Fill out all the employer application paperwork, including elections on your investment choices.
3. Review employee disclosures. Learn how the plan works, as well as employees’ rights and responsibilities.
4. Provider opens your solo 401(k). The account should be formed by your business’s tax filing deadline.
5. Fund your solo 401(k). Make contributions to your account in monthly installments or as a lump sum.

What information do I need?

When completing a solo 401(k) application, you’ll need the following details handy:

• Employer taxpayer ID number (EIN)
• Name and address of the plan administrator (the person who manages the account)
• Social Security number
• Phone number
• Email
• Address
• Government-issued ID

What brokers offer solo 401(k)s?

Brokerage firm	Fees	Account minimum
Fidelity	No setup or annual fee Standard commission fees: $0 stocks and ETFs, $0 options + $0.65 per contract	None
Vanguard	$20 annual fee per Vanguard fund, waived if you have at least $50,000 in qualifying Vanguard assets	None
Charles Schwab	No setup or annual fee Standard commission fees: $0 stocks and ETFs, $0-$50 mutual funds, $0 options + $0.65 per contract	None

While many brokers offer $0 commissions, you’re still responsible for fund expenses.

4 alternatives to solo 401(k)

If a solo 401(k) isn’t the right fit, consider these four individual retirement account options that generally boast a larger selection of investment choices and lower administrative fees than 401(k)s:

Traditional IRA

A traditional individual retirement account (IRA) is another investment account that offers tax benefits. Your contributions may be tax-deductible, and you only pay taxes when you withdraw from your IRA.
The maximum annual amount you can contribute in 2020 and 2021 is $6,000 — or $7,000 if you’re at least 50 years old.

Roth IRA

Roth IRAs offer similar perks to traditional IRAs, except that you fund the Roth account with post-tax money. That means your withdrawals are tax-free.

SEP IRA

A simplified employee pension (SEP) individual retirement account (IRA) is an employer-sponsored retirement plan. Only employers can make contributions to the account, and the amount can vary each year.
If you use self-employed income to fund the account, you’ll have a higher contribution limit than a traditional or Roth IRA. The max contribution amount $58,000 for 2021.

Defined benefit plans

A defined benefit plan is a pension plan that calculates your retirement benefits based on a formula. Several factors that impact your retirement amount include your length of employment and salary.
Unlike 401(k)s and IRAs, a defined-benefit plan doesn’t depend on investment returns.

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Bottom line

If your business is a one-man show, you can establish your own type of retirement account. But you’ll need to continually comply with the IRS guidelines for a solo 401(k), which can put a damper on things if you’re trying to grow your business.

Frequently asked questions

Here are a few other popular questions surrounding solo 401(k)s:

• What are the rules for withdrawing money from my solo 401(k)?

  After you turn age 59 1/2, you can start withdrawing your money as a lump sum distribution or periodic payments, such as an annuity or by installments. Your plan may also require you to begin withdrawing money on April 1 of the year you reach 72 years old, even if you haven’t retired yet.

• Can I borrow from my solo 401(k)?

  Yes. You may borrow up to 50% of your 401(k) balance up to $50,000 per participant. Most loans must be repaid within five years at an interest rate usually 1% to 2% higher than the prime rate.

• What happens if I shut down my business?

  If you close down your business, you’ll need to shut down your solo 401(k). But you may be able to rollover your funds into another account, such as an IRA.