Solo 401(k): Definition, rules & taxes

Being your own boss offers a lot of rewards. You're independent. You set your own schedule and choose the projects you'll do. But it also means you're entirely responsible for your own retirement savings plans.

As you look at retirement savings options for self-employed people, one plan to consider is a solo 401(k). These retirement savings plans can give you tax advantages similar to what employees of larger companies get with their 401(k)s. Let's review how they work.

An employer-sponsored 401(k) plan is the most common way to save for retirement. With a solo 401(k), you're the employer, and "solo" simply means that the plan is designed for a self-employed person (and their spouse) without other employees. Just like contributing to a regular 401(k), putting money into a solo 401(k) comes with tax advantages as an incentive to save—particularly if you don't access the money until after reaching age 59½.

With a solo 401(k), you defer a portion of your income into an account where you can invest your money and potentially grow it to use in your retirement years. You typically choose from a selection of stock and bond mutual funds offered by the provider you've selected to operate your solo 401(k). The interest, dividends and capital gains earned from these investments can compound in the account over time, progressively increasing the amount of money you will have when you retire.

Solo 401(k) rules allow self-employed people as well as business owners who have no employees other than their spouse to open and contribute to an account.

You even can have a solo 401(k) if you also work for another employer besides yourself. Just keep in mind that if your other employer has a 401(k) plan that you participate in, your annual contribution limit is for all your 401(k) accounts combined, not individually.

You can put money into your solo 401(k) in any way that works for you. You can take a certain percentage or amount from the payments you receive for your work, calculate an amount based on your income for each month or quarter or make a lump-sum contribution once a year.

But the biggest difference between a solo 401(k) and a regular 401(k) is that you can make contributions up to an annual limit both as the employee and the employer.

As an employee, you can contribute up to 100% of your compensation to a maximum of $23,000 in 2024. You can contribute an additional $7,500 if you are age 50 or older by the end of the year. The deadline for employee solo 401(k) annual contributions is generally Dec. 31 for the year, but sole proprietors and single-member LLCs have until Tax Day (usually April 15) of the following year to make contributions.

As the employer, you can contribute up to 25% of your employee's compensation to a maximum of $69,000 in 2024 to your employee's accounts, subject to certain limitations. See Publication 560 for a form to calculate your employer contribution amount.

Contributions you make as an employer may be deductible as a business expense and generally must be made by Tax Day (usually April 15) of the following year.

It's important to note, however, that the combined total of employee and employer contributions to your account cannot exceed $69,000 in 2024 plus the $7,500 catch-up contribution if you are 50 or older.

As with regular 401(k)s, the tax advantages and withdrawal rules for a solo 401(k) differ depending on whether you opt for a traditional or Roth version. Because you are your own employer, you get to choose which kind might be more advantageous for you:

With this tax-deferred setup, you put a portion of your income into the account before you pay taxes on it, so it doesn't count as part of your annual income at tax reporting time. You also don't pay taxes on the investment earnings while they accumulate in the account.

When you withdraw money from the account, that's when you'll pay regular income tax on whatever amount you take out. If you're not yet age 59½ and don't meet an exception when you withdraw money, you also may have to pay a 10% penalty on top of the income tax.

You can't let the money sit in the account forever without paying taxes, however. Once you reach a certain age, the IRS imposes required minimum distributions (RMDs), and you have to withdraw a certain amount every year so that taxes can be collected.

The Roth setup doesn't give you an immediate tax break. You pay regular taxes on the portion of your income you contribute in the year you earn it. But there are some key upsides: (1) If your plan allows in-service withdrawals or you already have retired, withdrawals of contributions will not be taxed or penalized; however, early withdrawals from your solo 401(k) will be prorated between contributions and earnings and such earnings may be taxed and penalized. (2) The investment growth in the account is never taxed unless you withdraw these earned amounts before age 59½ without meeting an exception or if you've held the account for less than five years. (3) Any withdrawals made after age 59½ are completely tax-free, as long as you've held the account for at least five years. (4) You won't be subject to RMDs.

Neither is definitively better. The value of the tax advantages that traditional and Roth solo 401(k)s offer depends on many factors, including which tax bracket you're in now versus which you expect to be in during retirement.

Organizing a solo 401(k) plan requires only a few steps:

• If you don't already have one, apply for an employer identification number (EIN). You must have an EIN to complete the account paperwork—you can't use your Social Security number.
• Choose the financial institution where you'll open the account. They'll provide you with a plan document that you'll fill out and sign.
• Establish the plan by Dec. 31 of the year you want it to take effect. While you may have until Tax Day of the following year to make employer contributions, the plan needs to have been opened within the calendar or fiscal year.
• Maintain the plan documents and keep up with administrative requirements every year.

Solo 401(k) plans provide a tax-advantaged way to save and invest your earned income to build up your retirement fund. But as a self-employed person or business owner, you have other retirement savings options you can consider. You may want to look at how a solo 401(k) stacks up against a SEP IRA, a SIMPLE IRA and traditional and Roth IRAs.

For expertise and guidance in deciding what type of retirement savings account might fit best with your individual situation and goals, connect with a Thrivent financial advisor.