The Ultimate Guide to the Solo 401(k), Written by a CPA Who Has OneSmall Business Taxes
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Many self-employed business owners wrongly assume that their retirement options are more limited than those available to employees of large corporations, who often have access to an employer-sponsored 401(k).
Well, entrepreneurs of America, I have some good news for you: as the owner of your own business, you can contribute to your own solo 401(k) — also known as an individual 401(k) — and the contribution limits are even greater than what a corporate employee would have.
This being said, the solo 401(k) rules can be a little complicated, but thankfully I have put together this guide for you.
Let’s start with the basics.
What Is a Solo 401(k)?
A solo 401(k) plan is a 401(k) for a self-employed individual. It retains all of the great, tax-saving features of a group 401(k) you would find at a large corporation — but with far less compliance to deal with. This is because most of the compliance involved with group 401(k) plans has to do with fairness among employees, but this obviously isn’t an issue for a self-employed person who will not seek to be unfair against him- or herself.
Solo 401(k) plans come by many other names, including:
- Individual 401(k)
- Single K
- Uni K
- Self-Directed 401(k), which is actually a specific kind of solo 401(k) plan that I discuss below
Of course, something as great as a solo 401(k) does come with rules and guidelines that must be followed, so read on.
Solo 401(k) Rules
Who Can Open a Solo 401(k)?
You can open a solo 401(k) if you meet all of the following requirements:
- You have self-employment income from your own personal effort. This includes not only small business owners but also those who work for another business as an independent contractor. However, passive investments such as rental real estate income do not count as “income from one’s own personal effort.”
- You report this income for tax purposes either through a C corporation, an S corporation, or as a sole proprietorship (whether you have a disregarded LLC does not matter).
- Your business, if you have one, has no non-owner “full-time employees.” For these purposes, “full-time employees” mean employees working more than 1,000 hours during the year for your business. Note that if you have, say, one business (Business A) that owns another business (Business B), and while Business A does not have “full-time employees,” Business B does, this could constitute a “controlled group” and would preclude you from opening a solo 401(k) for either of your two businesses. You may, then, have to open a more expensive and compliance-heavy group 401(k) plan. However, it is important to note that while the tax code permits these part-time employees, not all solo 401(k) plans do, so be sure to check with your provider first on their rules.
Can you open a solo 401(k) if you have a full-time job? If you have a W-2 job, and your self-employment income is from a “side hustle,” then you can still open a solo 401(k) as long as the requirements above are met. However, as I discuss below, you have to take into account your contributions to your day job’s 401(k) plan when determining your maximum contribution to your solo 401(k) plan.
Who Can Contribute to a Solo 401(k)?
Business owners and their spouses can contribute to a solo 401(k) plan.
Solo 401(k) Rules for Spouse: It’s important that each individual have their own, separate account. So while ABC Company could have a solo 401(k) plan called ABC Company Solo 401(k) Trust, Spouse A will have an account — say at a bank or brokerage firm — in the name of ABC Company Solo 401(k) Trust solely for his or her benefit, while Spouse B will have an account in the name of ABC Company Solo 401(k) Trust solely for his or her benefit.
Rollovers to a Solo 401(k)
Many small business owners wonder if they can roll a previous retirement plan into their solo 401(k). The answer to this question is generally “yes” with some important caveats below.
These Accounts Can Be Rolled Over to a Solo 401(k):
- Traditional, Rollover, or SEP IRA: can be rolled over to solo 401(k)
- SIMPLE IRA: can be rolled over to solo 401(k) as long as you have participated in your SIMPLE IRA for at least two years
- Former Employer’s Retirement Plan: can be rolled over to solo 401(k); note that you will receive a Form 1099-R but if you rolled over the entire balance correctly, the transaction will not be taxable. Also keep in mind that your former employer’s plan may have rules regarding how soon after you end your employment you may roll over your balance, so be sure to check with your former employer’s plan before attempting a rollover.
Note that indirect rollovers — in which you withdraw money from an old retirement account and then contribute it to your solo 401(k) within 60 days — may be done once every twelve months.
Pro Tip: None of the rollovers described above should be attempted on your own, else you may trigger a taxable event. It’s recommend that you work with a qualified provider to not only set up your solo 401(k) but also help you roll over your previous retirement funds into your new solo 401(k) if you so choose.
These Accounts Cannot Be Rolled Over to a Solo 401(k):
- Roth IRA: transfers from Roth IRAs to 401(k) plans are not permitted under the tax code. Note that this does not mean that you cannot use after-tax dollars to fund your solo 401(k); there is, in fact, a Roth solo 401(k) option that I describe later in this guide. Also, a Roth conversion may be done on funds that have been rolled over to your 401(k).
- Current Employer’s Retirement Plan: while rolling over your retirement plan you have with your current employer may be permitted under the tax code, it is very unlikely that your current employer’s plan would allow you to do so.
Solo 401(k) Contribution Limits 2020
This is one of the coolest parts of having a solo 401(k) — you can contribute nearly three times as much as you could to a 401(k) through a corporate employer!
Solo 401(k) contributions have two components: the “employee” component (also known as the elective deferral) and the “employer” component (also known as the employer nonelective contribution).
Now, the contribution limits are based on one’s earned income, so before we get into the specifics of the contribution amounts, we first have to discuss what “earned income” means in this context.
Defining “Earned Income”
In order to determine your solo 401(k) contribution limits for the year, you must first know your “earned income.”
If you have a C corporation or an S corporation, your earned income amount is easy to calculate: it’s the W-2 wages that are paid to you during the year by your S corporation. So if you receive wages of $100,000 during the year from your corporation, this $100,000 amount is your earned income.
Now, if you’re a sole proprietor — meaning that you report your business income or loss on Schedule C, which gets attached to your Form 1040 — your earned income is equal to your net earnings from self-employment as reported on Schedule C less one-half of your self-employment taxes paid. This is because you receive a deduction for one-half of your self-employment taxes paid on Schedule 1, Line 22, of your Form 1040. So if you net $100,000 in your sole proprietorship business for the year, and you owe $14,000 of self-employment tax on this income, your earned income would be $93,000.
Employee Component: Elective Deferral
Now that we’ve defined earned income for contribution limit purposes, we can get into the math.
The first component of solo 401(k) contributions is the elective deferral available to you as your own employee.
For 2020, you can contribute up 100% of your earned income as an employee up to:
- $19,500 for those under 50 years of age as of December 31, 2020, or
- $26,000 for those 50 years of age or older as of December 31, 2020.
It is important to note that if your self-employment income is a side hustle, and if you contribute to your 401(k) plan through your day job, then you must reduce the employee elective deferral amounts above by any amounts you have contributed to your corporate 401(k) plan through your employer.
What if you contribute more than is allowed? If you make a mistake and contribute more than the allowable amounts, you can withdraw the excess by April 15, 2021, without penalty, though you will still be subject to tax on any earnings on those overcontributions.
Employer Component: Employer Nonelective Contribution
The second component of solo 401(k) contributions is the nonelective contribution available to you as your own employer.
This contribution amount is based on a percentage of your earned income:
- Corporation shareholder-owners can contribute up to 25% of their W-2 wages.
- Sole proprietors can generally contribute up to 20% of their earned income.
Overall Solo 401(k) Contribution Limit for 2020
The overall 2020 solo 401(k) max contribution limits — after you combine both the employee piece and the employer piece — is $57,000 for those under 50 years of age and $63,000 for those 50 years of age or older.
However, as a C or S corporation owner, you’d have to be paying yourself a salary of around $150,000 before approaching these maximum contribution amounts! And remember, many corporation owners take most of their profits as distributions rather than wages to save on Social Security and Medicare taxes, so you’d realistically be looking at total corporation income before wages north of $300,000 or $400,000 before you have to worry about approaching these limits.
How to Set Up and Start a Solo 401(k)
Opening a solo 401(k) is surprisingly simple, and the fees aren’t terribly onerous either, especially if your needs are simple. Now, a solo 401(k) is not as inexpensive to set up as an IRA —which is typically free unless self-directed — but you still don’t have to break the bank to set up your plan either.
Here’s how to open a solo 401(k):
1. Ensure Your Eligibility.
The first step in setting up your solo 401(k) is making sure that you are, in fact, eligible to do so.
To do so, review the Who Can Open a Solo 401(k) section above and discuss your situation with your tax professional if you’re not sure about your eligibility to start a solo 401(k) plan.
2. Choose Your Solo 401(k) Provider.
The first step in setting up your solo 401(k) then is to choose your solo 401(k) provider, who will set up your documents and adoption agreement.
As you do your research, you will find that there are a wide range of providers at a variety of price points.
In general, your account and investment options will be more limited the less expensive your provider, while more expensive providers offer greater flexibility and more investment options for your account.
3. Open Your Account Before Year-End.
A solo 401(k) must be set up before December 31 for which you want to make contributions. So if you want to make 2020 contributions to a solo 401(k), you must set up your solo 401(k) plan on or before December 31, 2020.
This is different than a SEP or IRA, which you can set up after year-end.
Because setting up your account is a process — and because there’s generally a glut of procrastinating business owners who start the process in December — you should start the discussion with a solo 401(k) provider somewhere around October or November at the very latest.
How to Contribute to a Solo 401(k)
Payroll or Lump Sum
When it comes to funding your solo 401(k) plan, you have three options:
- Contribute via payroll deductions.
- Contribute via lump sum.
- Contribute via both payroll deductions and a lump sum.
Every solo 401(k) provider is different, so be sure to understand exactly how you can fund your solo 401(k).
Solo 401(k) Contribution Deadline
Note that the solo 401(k) contribution deadline is the extended due date of your individual tax return (if a sole proprietor) or your business tax return (if your business files its own tax return). Specifically, here are the solo 401(k) contribution deadlines for specific tax situations:
- Deadline for solo proprietor who has not extended Form 1040: April 15
- Deadline for solo proprietor who has extended Form 1040: October 15
- Deadline for S corporation owner who has not extended Form 1120S: March 15
- Deadline for S corporation owner who has extended Form 1120S: September 15
- Deadline for C corporation owner who has not extended Form 1120: October 15
So if you’re making solo 401(k) contributions, be sure to keep in mind the deadlines above.
Rolling Into a Solo 401(k)
As mentioned above, your solo 401(k) can accept tax-free rollovers from certain qualified retirement plans, including traditional IRAs, SEP IRAs, former employers’ 401(k)s, and more.
Rollover funds go to a pre-tax portion of your solo 401(k).
Note that rolled-over funds are not subject to the contribution limits or deadlines mentioned earlier in this article; you can roll over any amount of qualified funds into your solo 401(k) this year and still make your normal contributions by the deadlines stated above.
What Can a Solo 401(k) Invest In?
You can invest in almost anything with your solo 401(k) plan, apart from collectibles such as works of art or a stamp collection.
However, in order to have ultimate control over your solo 401(k) investments, you will need to set up a special kind of solo 401(k) called a self-directed solo 401(k).
Self-Directed Solo 401(k)
If you’re happy with these investment options, this could be a fine choice for you, and your fees will be relatively low.
But if you want to invest in things like real estate, precious metals, LLC or limited partnership interests, notes, and more, you will need to set up a more expensive self-directed 401(k) plan.
The one thing you have to watch out for, however, is the prohibited transaction rules below.
Prohibited Transactions and Self-Dealing
While you can invest in virtually any asset class through your solo 401(k) apart from collectibles, the one thing you can’t do with your solo 401(k) investments is self-deal.
What is self-dealing? Let me put it to you this way: if your solo 401(k) is engaging in a transaction with you (as an individual), your ancestral or lineal descendent, or a business entity controlled by you or one of these family members, you’re probably self-dealing through your solo 401(k).
These kinds of transactions are prohibited by the rules governing solo 401(k) plans, and you will be subject to taxes and penalties.
So Can I Invest in Real Estate in My Solo 401(k)?
Yes, you can, and this is a very popular investment choice for solo 401(k) owners.
Just make sure that you do not engage in any self-dealing / prohibited transactions in your real estate ventures.
For example, personally guaranteeing (as an individual) any loan taken on a property owned by your solo 401(k) would be considered self-dealing (this is why using leverage to invest in real estate through a solo 401(k) is typically done through a higher-interest non-recourse loan, meaning that the creditor can’t go after you personally).
Also, using (or allowing, say, a family member to use) a property owned by your solo 401(k) would also be considered self-dealing.
There are some other traps that one can fall in when investing in real estate through a solo 401(k), so be sure to work with a qualified professional who can guide you along the way.
Can I Invest in Business in My Solo 401(k)?
Yes, you can! As long as your solo 401(k) doesn’t engage in any prohibited transactions, it can invest in C corporations, LLCs, and limited partnerships.
Did you notice what’s missing from that list? S corporations. Solo 401(k) plans may not hold S corp shares, but this is not due to the rules governing Solo 401(k) plans; this is due to the S corporation rules, which state that only individuals (including certain single-member entities), certain trusts, and estates.
Solo 401(k) Frequently Asked Questions
Can I Take A Loan From My Solo 401(k)?
Yes, you can take a loan from your solo 401(k), up to 50% of the account value and no greater than $50,000.
So if you have a $60,000 balance in your solo 401(k), the maximum you could borrow is $30,000.
If you have a $100,000 balance in your solo 401(k), the maximum you could borrow is $50,000.
And because the loan can be no greater than $50,000, even if you have a $1,000,000 balance in your solo 401(k), the maximum you could borrow is $50,000.
This loan must be paid back within five years, with interest.
What’s This “Checkbook Control” I Hear About?
What “checkbook control” is referring to is that as the trustee of your solo 401(k) plan, you can have direct control of the plan assets.
There doesn’t have to be a third-party trustee who has the final say over what your plan invests in.
You just write a check from the solo 401(k) in order to invest.
Is There Such a Thing as a Roth Solo 401(k)?
Yes, a solo 401(k) plan may have a Roth component.
However, only the “employee” contribution piece can be contributed to a Roth solo 401(k) account.
In the same year, you may make both traditional and Roth solo 401(k) contributions.
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Logan is a practicing CPA, Certified Student Loan Professional, and founder of Money Done Right, which he launched in 2017. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.