A self-employed 401(k)—also called a solo-401(k) or an individual 401(k)—is a special savings option for small-business owners who don't have any employees (apart from a spouse). That makes these accounts a good fit for sole proprietors and independent consultants who are looking for a retirement plan similar to one they might get from working at a larger company.
In many ways, the self-employed 401(k) works the same way as a standard 401(k). Participants make contributions from their pre-tax earnings, and those savings can be invested in a range of vehicles to grow tax-deferred until withdrawn in retirement.
However, the self-employed 401(k) does come with one crucial difference. Because participants are acting as both employer and employee, they can set aside more money each year than they could under a traditional 401(k), IRA, or other small business retirement account. Those high contribution limits, plus relatively easy plan administration, make the self-employed 401(k) an appealing option for business owners who meet the plan's requirements and want a significantly higher savings potential.
The highlight of the self-employed 401(k) is the ability to contribute to the plan in two ways. For 2020 and 2021, as an employee, you can make salary deferral contributions equal to the lesser of $19,500, or 100% of your compensation. If you're at least 50 years old, your savings options are even higher because you can add an extra $6,500 (for 2020 and 2021) in catch-up contributions each year.
Then, as the employer, you can make a contribution of up to 25% of your compensation each year, up to a maximum of $57,000 in 2020 and $58,000 in 2021 in combined contributions each year (if you are over 50, your combined employee and employer annual contributions can't exceed $63,500 for 2020 and $64,500 in 2021).
Together, those contributions can add up to significant annual savings. For example, if you're an independent consultant (with no employees) with 2020 W-2 wages of $100,000, you could first contribute up to $19,500 as an employee. Then, as the employer, you could contribute $25,000 more based on your compensation minus business expenses and self-employment taxes. In total, you could set aside $44,500 in one year to help build your retirement nest egg.
Self-employed 401(k) contributions may also make you eligible for added tax breaks. If your business is not incorporated, you can generally deduct contributions for yourself from your personal income. If your business is incorporated, you can count the contributions as a business expense.
If you decide that a self-employed 401(k) is a good match for your situation, you can set one up through a financial institution that administers 401(k) plans. Because these plans involve only 1 or 2 people, they're much simpler to administer than a traditional 401(k). Accordingly, fees also can be relatively low, with some institutions not charging any setup or maintenance fees for a self-employed 401(k).
When reviewing potential plan administrators, make sure you're aware of all applicable fees before signing up. You may also want to look for a plan that offers a wide range of investment options, including mutual funds, stocks, bonds, ETFs, and CDs. Some institutions also offer online tools or telephone assistance to help you pick the right mix of investments for your plan.
Once your plan is up and running, there's very little work beyond establishing contribution levels and choosing investments for those funds. There is no annual minimum contribution requirement, so you can increase contributions in good years and save less during times when you need more cash for your business. One caveat: If your account amasses more than $250,000, you will need to file IRS Form 5500-SF, the Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan, which details the financial condition of your self-employed 401(k).
Withdrawing funds from a self-employed 401(k)
As with traditional 401(k) plans, the self-employed 401(k) is intended to help you save money for retirement, and there are regulations in place to encourage you to do so. For example:
- Withdrawals prior to age 59½ may be subject to a 10% early withdrawal penalty, along with any applicable income taxes1
- You must take required minimum distributions from self-employed 401(k)s beginning at age 722
- Plans can be structured to allow loans or hardship distributions3
- Plans can be structured to accept rollovers from other retirement accounts, including SEP IRAs and traditional 401(k)s, into your self-employed 401(k)
- You can roll your self-employed 401(k) assets into another 401(k) (assuming the employer's plan allows rollovers) or an IRA
Because of its high contribution levels, flexible investment options, and relatively easy administration, the self-employed 401(k) is an attractive option for small-business owners or sole proprietors who want to be able to save aggressively for the future.
If there is the potential that your business might add employees at a later date, however, know that you will either have to convert your self-employed 401(k) plan to a traditional 401(k), or else terminate it. But if you're confident that you will remain a one-person operation, and you want the high savings options that these plans offer, this type of account may be a good fit.
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