Solo 401(k)

Solo 401k rules

If you have a Solo 401(k), there are certain Solo 401(k) rules that you must observe when you contribute or withdraw funds. Here is everything you should know.

3 min read

If you are self-employed, you can still reap the benefits of a retirement plan by opening a Solo 401(k) account. This retirement account offers similar benefits to a 401(k), and you can set aside a bigger portion of your annual income towards your retirement. You can open a Solo 401(k) as the sole retirement savings vehicle, or use the Solo 401(k) alongside other retirement accounts such as a 401(k) or an IRA. Before setting up a Solo 401(k), you should understand the Solo 401(k) rules so that you can maximize your retirement contributions.

To be eligible for a Solo 401(k), you must be self-employed and earning some form of self-employment income. The business should not have employees except your spouse and business partners. You can contribute to the Solo 401(k) both as an employee and an employer; cumulatively, you can contribute up to $58,000 in 2021, or $64,500 if you are age 50 or below. You can choose to contribute to a traditional Solo 401(k) or Roth Solo 401(k) account.

Eligibility Rules for Solo 401(k)

A Solo 401(k) is intended for self-employed business owners with no employees, other than yourself, spouse(s), and business partners. You must also have self-employment income and provide proof of income. If the business has full-time employees, you could consider other types of retirement plans such as a SEP IRA or SIMPLE IRA, which provide various tax benefits to business owners and their employees.

A business that is structured as a sole proprietorship, partnership, LLC, or corporation may qualify to open a Solo 401(k), as long as it is engaged in a trade or business to generate a profit. Only businesses providing an active business endeavor are eligible; businesses that earn a passive income such as rental income are not eligible to join a Solo 401(k). Various types of businesses such as independent consultants, real estate agents, financial advisors, physical fitness trainers, adult care providers, and professional service providers (e.g. CPAs, Attorneys) may open a Solo 401(k) account if they meet the eligibility requirements.

Solo 401(k) Contribution Limits

Solopreneurs can set up a Solo 401(k) with a brokerage and start making contributions both as an employee and employer. As an employee, the business owner can save up to $19,500 yearly as elective deferrals in 2020 and 2021, or up to 26, 000 if he/she is age 50 or older.

As an employer, the business owner can contribute up to 25% of the net adjusted self-employed income. The combined contributions cannot exceed $58,000 annually in 2021 ($57,000 in 2020), or 64,500 if you are above age 50. The limit on business income used in determining the annual contribution is $285,000 for 2020 and $290,000 for 2021. The business owner must contribute by the Solo 401(k) contribution deadline i.e. April 15, or October 15 if an extension is filed.

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

If you are self-employed and work at a second job, you can have a Solo 401(k) and a regular 401(k) at the same time. The contribution limits are calculated cumulatively across both retirement accounts. For elective deferrals, you can set aside up to $19,500 in 2021 across both accounts. If you max out the elective deferrals in the 401(k), you cannot make employee contributions in the Solo 401(k).

However, employer contributions are calculated per plan, and two unrelated employers can each contribute up to the IRS annual limit. You can contribute up to 25% of the compensation earned per unrelated employer. You can contribute up to $58,000 to your Solo 401(k) in 2021, and another $58,000 to your 401(k) account. If you are over 50, you can make catch-up contributions of $6,500 to only one retirement account.

Covering Spouse under a Solo 401(k)

The singular exemption to the no-employee rule of a Solo 401(k) is a spouse involved in the business. If your spouse is a part-time or full-time employee of the business and derives an income from the business, they can contribute to the Solo 401(k) up the contribution limit. As an employee, the spouse can make elective deferrals to the Solo 401(k) account up to the $19,500 annual limit ($26,000 if they are 50 plus). As the employer, you can also make profit-sharing contributions to the spouse's Solo 401(k) account up to 25% of their compensation, or $58,000 in 2021, whichever is lower.

Solo 401(k) Early Withdrawal Rules

Depending on whether you withdraw money from your Solo 401(k) before or after retirement age, you may owe income taxes and penalties on the amount withdrawn. If you withdraw funds from a traditional Solo 401(k) before you are 59 ½, you will owe income taxes on the amount withdrawn at your tax bracket, and an additional 10% penalty for early withdrawal.

If you have a Roth Solo 401(k), early withdrawals are not subject to income taxes and the 10% penalty tax, as long as you’ve held the account for at least five years. Contributions to a Roth Solo 401(k) are taxed in the year they are earned, and therefore, withdrawals from the Roth Solo 401(k) are not taxed. However, you will pay taxes and penalties on any earnings generated from the Roth Solo 401(k) contributions.

Solo 401(k) Withdrawals in Retirement

Once you’ve attained age 59 ½, you can start taking distributions from your Solo 401(k) account. If you have a tax-deferred Solo 401(k), you will owe income taxes on the amount withdrawn based on your tax bracket rate. However, you won’t pay a 10% penalty tax since you have already attained retirement age. For a Roth Solo 401(k), you can take tax-free distributions if you have made contributions to the account for at least five years.

With a Solo 401(k), you must start taking Required Minimum Distributions (RMDs) in the year that you turn 72. You must also take distributions in subsequent years after the year you turn 72. The distributions you take are included in your taxable income for the year, except for any contributions that were taxed before. You still have to take the mandatory distributions even if you have a Roth Solo 401(k). You can avoid taking RMDs by rolling over your Solo 401(k) into a Roth IRA, which does not require retirement savers to start taking RMDs when they turn 72.