Solo 401(k)

What are the Advantages of a Solo 401k?

A solo 401(k) is ideal for self-employed individuals who are looking to maximize their retirement savings. Find out the advantages of a Solo 401(k).

4 min read

If you are a small business owner or solo entrepreneur looking for an alternative retirement savings option, you have likely come across a Solo 401(k). This retirement savings account allows self-employed individuals to contribute both as an employee and employer, hence increasing their savings potential.

As a business owner, you can open a Solo 401(k) account to help you build enough savings to live off in retirement. Some of the advantages of a Solo 401(k) include higher contribution limits of up to $58,000 annually, a Roth component, Solo 401(k) loans, and unlimited investment options.

Advantages of a Solo 401(k)

Some of the key benefits of a Solo 401(k) plan that makes it attractive to business owners include:

Higher contribution limits

A Solo 401(k) participant can make an employee deferral contribution of up to $19,500 in 2021. You can contribute up to 100% of your earned income, as long as the contribution does not exceed the $19,500 limit. If you are over 50, you can contribute an additional $6,500 in catch up contributions, which adds up to $26,000. This is higher than the IRA limit, which allows a $6000 contribution limit and an extra $1000 catch-up contribution.

As the employer, a Solo 401(k) allows you to contribute up to $37,500, as long as this amount does not exceed 20% of your self-employment income. In total, you could potentially save $58,000 if you are below 50, or up to $64,500 if you are above age 50 in 2021.

Unlimited Investment Options

Traditional retirement plans restrict participants to a select number of investments such as stocks, bonds, and mutual funds. However, a Solo 401(k) allows you to self-direct your retirement money, and you can invest in any type of investment you want. You can invest in real estate, structured settlements, mortgage notes, private equity, precious metals, and tax liens. This allows you to diversify your investments so that your retirement money is not restricted to just one type of investment.

Roth Saving Option

A Solo 401(k) allows participants to choose between a traditional plan and a Roth plan, depending on which option works for them. With a Roth plan, you can make deferred contributions to the account with after-tax dollars. Unlike a Roth IRA that restricts participants with higher incomes, a Roth component with a Solo 401(k) does not have income restrictions. You can use a Roth plan to let your funds grow in a tax-free environment, such that you won't owe any taxes when you take distributions in retirement. Any gains on investments within the Roth plan are tax-free, and you keep all the returns on the assets.

Participant Loans

If you need a quick cash injection into your business, you can borrow up to $50,000 or half of your account balance from your Solo 401(k) account. You can borrow to pay for college, pay a personal dent, buy a house or use it to buy a business. When you borrow from your 401(k) plan, you are not subjected to a credit check, and you can determine how you want to spend that money. A Solo 401(k) loan has a low-interest rate, and it is pegged on the prime rate. Therefore, borrowing from a Solo 401(k) provides better terms than taking a bank loan, which would require a good credit score and collateral for the loan.

Exemption from UDFI

When you use your IRA to buy real estate with borrowed funds, any income earned from the property is subject to Unrelated Debt Financed Income Tax. You will owe taxes on the net rental proceeds, or net profits obtained from selling the leverage real estate. With a Solo 401(k), you can avoid paying the UDFI tax on leveraged real estate. This exemption provides a tax advantage to business owners for using a Solo 401(k) plan to purchase real estate.

For example, if you buy a real estate property at $100,000 and you borrowed $50,000 of this money, it means you have 50% debt on the property. In an IRA environment, you will pay UDFI taxes on 50% of the net profits from the property. However, there is no UDFI tax on Solo 401(k) investments arising from debt on real estate. Any income earned from the real estate property will grow tax-deferred even though you borrowed $50,000 of the $100,000 used to purchase the property.

Retirement Savings Consolidation through Rollovers

If you have old 401(k)s left with former employers, you can rollover these funds to the Solo 401(k) plan. You can also rollover funds from other types of retirement accounts such as IRA or SEP accounts to consolidate your retirement savings into one account. This will help you access a higher loan, or get enough funds to invest in your preferred investment classes.

No third party custodian

When you open a Solo 401(k), you become your own trustee. You have the freedom to make investments and enter into transactions on your own. This eliminates the delay and costs involved when using a third-party custodian. You also get checkbook control, and you can sign and send checks to make investments when an investment opportunity is available.

Disadvantages of a Solo 401(k) Account

Some of the limitations of a Solo 401(k) account include:

No Employees

If you are interested in opening a Solo 401(k), your business cannot have employees other than you (the owner) and spouse(s). If your business has employees or you plan to hire employees in the future, a Solo 401(k) may not be an ideal option for you. Instead, you would be better off with another retirement savings account such as a SEP IRA.

Recurring Contributions

When you open a Solo 401(k) account, the IRS requires participants to make substantial and recurring contributions for the account to remain active. If you make contributions irregularly, or the amount contributed is not significant enough, the IRS may consider the account to be inactive.