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Is a Solo 401(k) a Good Choice When You’re Self-Employed?


The sole proprietor 401(k) is a retirement plan designed for small-business owners who don’t have any employees or only a spouse as their sole employee. It allows participants to invest more money than they could through a traditional 401(k). As you explore the benefits of the sole proprietor 401(k) to see if it’s the right choice for you. We can also help you find a financial advisor who can guide you through making the right retirement planning decisions.

What Is a Sole Proprietor 401(k)?

A sole proprietor 401(k) goes by many names. These include the following

However, it works quite differently than a traditional 401(k). The mechanics of the solo 401(k) make them attractive to small-business owners. It’s also relatively easy to manage.

How Does a Solo 401(k) Work?

Solo 401(k)s work much like their traditional counterparts. You invest in it with pre-tax money. This means your contributions reduce your taxable income, so the government taxes you as if you made less money during the year. In addition, your earnings grow tax free until you make eligible withdrawals upon retirement.

And because a Solo 401(k) usually supports one or two people, the financial institutions that administer these plans typically charge very low fees for their services. Moreover, they also tend to offer a wide range of investment choices. Most 401(k) plans limit employees to a specific menu of funds. But you can find a solo 401(k) that would let you invest in virtually any security including the following.

Regardless of what you invest in through your solo 4o1(k), you should choose an asset-allocation that reflects your time horizon and risk tolerance.

Sole-Proprietor 401(k) Contribution Limits

When you invest in a solo 401(k), you act as the employee and the employer. This is why the IRS allows larger maximum contributions toward the sole-proprietor 401(k) than it does for the traditional 401(k) sponsored by companies with several employees.

Here’s how that works. As an employee, you can contribute up to $19,000 to your solo 401(k). If you’re at least 50-years-old, you can contribute an additional catch-up contribution of $6,000.

As your own employer, however, you can contribute up to 25% of your own compensation toward the plan up to a maximum of $56,000 in 2019. If you’re at least 50 years old, your employee plus employer contributions can reach $62,000.

Taking Distributions from Your Plan

Solo 401(k)

The IRS has specific guidelines on when you can withdraw money from a 401(k), whether it’s a traditional or solo account. Generally, you must be age 59.5 before you can tap into your nest egg; otherwise, you’ll face a 10% early withdrawal penalty. Not only that, but you’ll also have to pay income taxes on the money. There are some exceptions for taking money out penalty-free, such as buying a first home or if you become permanently disabled.

If you wait until you reach the age cutoff to start withdrawing funds, there are no penalties, but you’ll still have to treat it as income for tax purposes. The upside is that any contributions you make are deductible as a business expense. If you’d rather defer the tax break until later, you can designate your solo 401(k) as a Roth account, which means any qualified withdrawals you make later on would be tax-free.

Solo 401(k) Rules

Beyond withdrawal restrictions on sole-proprietor 401(k)s, the IRS also imposes some other rules. Many of these apply to traditional 401(k)s as well. For instance, you must begin taking required minimum distributions (RMDs) at age 73 if you turn 72 in 2023.

Some plan administrators structure solo 401(k)s in a way that allow hardship distributions before you turn 50.5. However, there are usually very limited exceptions and you’d likely face the 10% early-withdrawal penalty tax. Some plans also permit rollovers from other retirement plans. But be sure to check with your plan administrator for the latest information.

In addition, you must file IRS Form 5500-EZ if your account balance exceeds $250,000.

Should You Contribute to a Solo 401(k)?

In terms of the tax benefit and the higher contribution limits, a solo 401(k) has the edge over other kinds of individual retirement accounts. Depending on where you open your account, you may even be able to borrow against your balance with a 401(k) loan. There is a downside, however, since setting up and managing the plan is usually a bit more intensive. You’ll have to file a special form with the IRS each year if your account balance exceeds $250,000, and you may find that the fees are somewhat higher than what you’d pay for an IRA.

The Takeaway

When you’re trying to decide which savings vehicle is best, it’s important to look at how much you have to contribute and what kind of tax benefit is most useful. If you only have a few thousand dollars to set aside each year, or you think you may hire an employee or two down the road, you’re better off looking into another retirement option. If you opt for a solo 401(k), go with solo 401(k) providers who offer low fees.

Retirement Planning Tips

  • A financial advisor can help you with retirement planning. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Regardless of what type of retirement plan you invest in, make sure you look out for fees and use low-cost funds. To help you decipher these, we published a report on everything you need to know about 401(k) plan fees. These are very similar to the kind you’d find with a solo 401(k).

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