Are You Self-Employed? Check Out a Solo 401(k)

Just because you’re self-employed doesn’t mean you can’t reap the benefits of a workplace retirement plan. Check out a solo 401(k), which offers similar tax benefits to an employer-sponsored 401(k), plus you can sock away almost 10 times more per year than in an individual retirement account (IRA).

What Is a Solo 401(k)?

A solo 401(k) is a tax-advantaged retirement account for self-employed business owners and spouses who work for them at least part-time.

The Solo 401(k) is also known as an individual 401(k), one-participant 401(k) plan or a self-employed 401(k). People who have full-time jobs with access to workplace retirement plans may also save for retirement in a solo 401(k), using money earned from a side hustle.

There are no age or income restrictions limiting who can open and save in a solo 401(k). You may be able to contribute up to $69,000 in 2024. For 2023, that limit is $66,000. It was $61,000 in 2022.

Workers age 50 or older can kick in additional amounts. They can pony up so-called catch-up contributions of as much as an additional $7,500 in both 2024 and 2023. The catchup contribution limit was $6,500 in 2022.

Solo 401(k) vs SEP IRA

When deciding how to save for retirement, small business owners with no employees (beyond their spouses) generally choose between a solo 401(k) and a Simplified Employee Pension IRA (SEP IRA).

Both accounts give the self-employed a tax-advantaged way to invest money for retirement, but there are a few key differences that could make the solo 401(k) a better fit:

You may be able to save more with a solo 401(k). With a SEP IRA, your total contributions for 2024 cannot exceed 25% of your first $345,000 (up from $330,000 for 2023) of net adjusted self-employed income or up to $69,000 (up from $66,000 for 2023), whichever is less. (That 25% is 20% if you’re set up as a sole proprietorship and pay yourself out of business profits rather than from W-2 wages. Unless your business income is substantial, you may be able to save more in a solo 401(k). How so? Unlike solo 401(k)s, SEP-IRAs can’t offer catchup contributions. So in 2024 a solo 401(k)’s combined potential retirement savings total $76,500 vs. just $69,000 with a SEP-IRA. True, a SEP-IRA owner can more than close that gap by contributing to a traditional or Roth IRA as well. However, solo 401(k) owners can also make those additional savings moves, giving them a total combined savings edge again, says Cody Waight, a retirement compliance specialist for American Century Investments. “But Roth contributions would likely not be allowed due to the high income level of someone who is able to max out these contributions,” Waight adds.
You can make both employer and employee contributions. Like a workplace 401(k), there are “employer” and “employee” contributions for solo 401(k)s. You can contribute up to $22,500 of your pay as an employee in 2023 (up to $23,000 in 2024). As an employer (you work for yourself), you can also make a profit-sharing contribution. That can be either 20% or 25% of your net business income self-employment income or your W-2 wages, depending on how your business is set up. Once you add up contributions from all of your sources including catchup contributions, you can salt away as much $73,500 in 2023 and $76,500 in 2024.
There’s a Roth solo 401(k) option. If you’d prefer to make tax-free withdrawals in retirement, you may want to choose a Roth solo 401(k). Starting in 2023, SEP IRAs can be set up as Roth accounts, point out Tami Guimelli and Robin Revzin, retirement rules experts for John Hancock Retirement.
Catch up contributions for savers who are 50 or older. For people who are 50 and older, a solo 401(k) allows you to make additional catch-up contributions as an employee, $6,500 in 2022, $7,500 in 2023 and $7,500 in 2024. SEP IRAs are only funded with employer contributions, so catch-up contributions are not allowed.

Tax Advantages of the Solo 401(k)

Whether you choose a traditional or Roth solo 401(k), you get valuable tax advantages. Contributions to a traditional solo 401(k) reduce your taxable income today. And you can make Roth solo 401(k)s contributions no matter how much you earn each year, as with a conventional Roth 401(k).

Traditional Solo 401(k)

Contributions to a traditional solo 401(k) let you reduce your taxable income, helping to reduce your tax bill. Any money you invest then grows tax deferred until retirement. Withdrawals you make in retirement are taxed as regular income. You may owe a 10% penalty in addition to ordinary income taxes on withdrawals you make from a traditional solo 401(k) before age 59 ½.

Roth Solo 401(k)

A Roth IRA has income caps that prevent high earners from making contributions, but there are no income limits with the Roth solo 401(k). Like other Roth accounts, contributions come from income that’s already been taxed. Instead of an upfront tax break, any withdrawals from a Roth solo 401(k) made after age 59 ½ are tax free, as long as you make them at least five years after you began making contributions.

You may face penalties if you withdraw money saved in a solo 401(k) before you turn 59 ½. A Roth solo 401(k) lets you withdraw contributions—but not investment earnings—tax- and penalty-free. But because you cannot choose to withdraw contributions exclusively, at least part of your withdrawals will be subject to taxes and penalties.

Should I Choose a Traditional or Roth Solo 401(k)?

For many investors, deciding between a traditional or Roth solo 401(k) comes down to whether you believe you’re in a lower tax bracket today than you will be in retirement. If you think you are paying lower taxes now, you might choose a Roth solo 401(k). If you anticipate being in a lower tax bracket in retirement, a traditional solo 401(k) may be a better bet.

There’s another wrinkle with a Roth solo 401(k) account: You can only contribute up to $22,500 in 2023 and $23,000 in 2024, plus catch-up contributions if you’re 50 or older. If you’re able to save more than this amount, you will need to contribute that extra amount into a traditional solo 401(k) account. You can make both “employer” and “employee” contributions to a solo 401(k), but your “employer” contributions cannot be saved in a Roth account.

That may be just as well because many financial advisors feel it’s a good idea to hedge your bets for any tax scenario by investing in a mix of pre-tax and after-tax retirement accounts. “[It gives you] room for strategy in the future,” says Shon Anderson, a certified financial planner (CFP) in Dayton, Ohio. Ultimately, the choice of whether to invest your money in a traditional solo 401(k) versus a Roth solo 401(k) is a matter of age, income, location and preference.

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Other Benefits of Solo 401(k)s

The advantages of solo 401(k)s aren’t limited to taxes. If your spouse works with you at your company—even part-time—they may be able to invest in a solo 401(k) as well.

As long as your husband or wife works for you at least part-time, they can contribute up to $22,500 for 2023 to a solo 401(k), plus catch up contributions if they’re 50 or older. That contribution cap rises to $23,000 for 2024. Catch-up contributions can be as high as $7,500 in 2023 and 2024.

You, as their employer, can then contribute up to 25% (sometimes just 20%) of their compensation, up to a total of $66,000 in 2023 and $69,000 in 2024. This allows couples to invest more than $100,000 in tax-advantaged retirement accounts.

You Can Take a Loan from Your Solo 401(k)

Most solo 401(k) providers let account owners take out 401(k) loans from their accounts. With a solo 401(k), you can borrow up to the lesser of 50% of the plan value or $50,000. You must pay back the loan in five years or less—unless it’s used to buy a primary residence, in which case you have up to 30 years.

Just because you’re borrowing from yourself doesn’t mean it won’t cost you. You’re required to pay your account interest comparable to what you’d pay for a similar non-401(k) loan. You’ll also miss out on potential returns that money would have earned if it had stayed invested.

While you will eventually “earn” what you borrow back, plus interest, that interest rate may be less than the returns the money would have earned if you had left it untouched and invested in the stock market.

Solo 401(k) Contribution Limits

Solo 401(k) contribution limits are the lesser of $66,000 in 2023 ($69,000 in 2024), or 20% or 25% of your net adjusted self-employed income, up to limits we detailed earlier in this report, depending on how your business is structured. This total rises to $74,500 in 2023 and $76,500 in 2024 when including catch-up contributions for those who are 50 or older.

With a solo 401(k), you make contributions as both “employee” and “employer.” As an employee, you can contribute up to $22,500 in 2023 and $23,000 in 2024, or up to $30,000 and $30,500, respectively, if you’re 50 or older. As an employer, you can contribute up to 20% or 25% of your net adjusted self-employed income. We went over the fine print earlier.

The IRS calculates this as your net earnings from self-employment minus one-half of your self-employment tax and employee contributions you made for yourself. In 2023, employee and employer contributions cannot exceed $66,000 or $73,500 for those 50 or older in 2021. In 2024, this rises to $69,000 or $76,500.

You have until the tax filing deadline for that tax year to complete all contributions—April 15th, or October 15th if you file for an extension—but you must establish the 401(k) plan before the end of a calendar year to make contributions for that year.

Contribution Limits If You Participate in Another 401(k) Plan

If you have a solo 401(k) and you also work for another company and participate in its 401(k) plan, the limits on employee contributions are cumulative across all accounts. The employer contribution limits are based on plans, meaning two unrelated employers can contribute up to the employer maximum annually.

Note that anyone who is considering a solo 401(k) to save earnings from a side job for retirement should check first with a tax professional, who can help confirm your eligibility for the account, including your self-employment status.

How Do Solo 401(k) Withdrawals Work?

Depending on when you withdraw money from your solo 401(k) and which type of account you withdraw from—traditional or Roth—you may owe taxes or penalties. Here’s what you need to know about possible taxes or fees on solo 401(k) withdrawals.

Solo 401(k) Early Withdrawal Rules

Early withdrawal rules for solo 401(k)s depend on which type of account you have. With a few exceptions, you must pay a 10% penalty tax on withdrawals from a traditional solo 401(k) account made before you turn 59 ½, plus income taxes on the amount withdrawn.

With a Roth solo 401(k), early withdrawals of contributions are free of the 10% tax penalty and income tax payments, but you pay the penalty and income tax on earnings. You cannot withdraw contributions exclusively, meaning you will have to pay taxes and a penalty on at least part of your early withdrawal.

Exceptions for Solo 401(k) Early Distribution Penalties

The IRS may waive the 10% penalty for early withdrawals in certain circumstances. You’ll still owe taxes on any contributions or earnings that haven’t been taxed. The exceptions include:

Medical expenses that exceed 10% of your adjusted gross income
Permanent disability
Certain military service
A Qualified Domestic Retirement Order (QDRO) issued as part of a divorce or court-approved separation

In the case of a distribution paid to an ex-spouse under a QDRO, the 401(k) owner owes no income tax and the recipient can defer taxes by rolling the distribution into an IRA.

Unlike an IRA or SEP IRA, a solo 401(k) doesn’t allow penalty-free withdrawals for higher education expenses or first-time homebuyers.

Solo 401(k) Withdrawals in Retirement

Withdrawals from your solo 401(k) after age 59 ½ incur no penalties, though income taxes depend on which type of account you have.

If you have a Roth solo 401(k), withdrawals are tax-free if made at least five years after the first contribution to the account. If you have a traditional solo 401(k), you pay income taxes on withdrawals based on your current tax bracket.

With a solo 401(k), you eventually are required to begin taking withdrawals from your account, known as required minimum distributions (RMDs). You can avoid RMDs requirements by rolling a Roth solo 401(k) into a Roth IRA, which does not have mandatory RMDs.

For solo 401(k)s, you must take your first RMD by April 1 of the year after you turn 72. If you turn 72 on or after January 1, 2023, you must take your first RMD by April 1 of the year after you turn 73. Either way, in subsequent years, RMDs must be taken by December 31 of the relevant year.

How to Open a Solo 401(k)

Opening a solo 401(k) isn’t difficult, but timing is important. The deadline to establish a solo 401(k) for you and your business is December 31 of the year you want to contribute. Here’s how to open a solo 401(k):

Choose your provider. Most online brokers offer solo 401(k)s. Generally, you’ll want to pick the broker whose investments you prefer. Roth solo 401(k)s are not as common as traditional solo 401(k) offerings, so check to make sure your brokerage offers them.
Get an EIN number. You can get an Employer Identification Number, which is essentially a tax ID for employers, from the IRS.
Fill out an application and any required plan documents. Because this is a retirement plan, the IRS requires some paperwork. Your broker will provide you with the documents you need and can guide you through the process.
Fund the account. You can fund the account by rolling over money from another retirement account or setting up a transfer from a checking or savings account.
Choose investments. As with any retirement account, you’ll need to determine how you want your money invested.