The solo 401(k) is designed to solve a very particular problem. What if you work for yourself instead of for another employer? How can you start saving for retirement responsibly and in a tax-advantageous way?

Well, the solo 401(k) is the way. This retirement plan allows self-employed people and solopreneurs to have their own retirement account so they can build tax-advantaged savings and sleep easier at night.

In this article, we will delve into what a solo 401(k) is, who is eligible to participate in it and how it differs from a traditional 401(k) plan.

A young man by himself in an office - he saves his money for retirement in a solo 401(k)

What Is a Solo 401(k)?

A solo 401(k) is a type of retirement plan that allows self-employed individuals to save for retirement and take advantage of favorable tax consequences.

There are currently around 16 million self-employed people in the United States, according to the Bureau of Labor Statistics. Unlike a full-time worker at a large corporation, these people do not have access to a traditional 401(k). The solo (or individual or one-participant) 401(k) is a solution for these people.

To be eligible to have one of these retirement accounts, you must own a business but have no full-time employees. In essence, you work for yourself and by yourself.

This plan offers many of the same benefits as a traditional 401(k). You’re able to contribute pre-tax dollars to it to help you save for retirement, and the money in the account can grow tax-deferred until you reach retirement age.

However, it does have a number of features that make it different from the traditional account. For example, you may contribute to it as both an employer and an employee. Plus, your spouse may be able to contribute as well.

How Much Can You Contribute?

Like a traditional 401(k), with a solo 401(k) you can make regular contributions to your retirement account. However, there are limits to how much you can contribute each year.

Solo accounts allow you to contribute quite a bit more than traditional accounts. A self-employed worker may contribute up to $61,000 in 2022.

Plus, if you are age 50 or older, you are allowed to make additional “catch up” contributions of $6,500, which would put you up to a total of $67,500 in 2021.

These payments are broken into both an employer contribution and an employee contribution. Technically, the same person is playing both roles here, but it breaks the contributions down into specific limits for each component.

As the employee, you have the same $20,500 contribution limit that you would have in a traditional retirement account. But as the employer, you contribute a percentage of your business’s earnings up to $305,000 in 2022.

Tax Advantages of the Solo 401(k)

The major benefit of a solo 401(k) is its tax advantages. These allow you to invest your pre-tax money for retirement and let it grow tax-deferred until you’re ready to retire.

Because the money you put in your account is pretax dollars, it reduces your total taxable income for the year. If you earn $3,000 per paycheck and put $300 per paycheck in your retirement account, you will be be taxed for an income of only $2,700 per paycheck this year. That saves you money now.

Like a traditional 401(k) as well as an IRA, the solo 401(k) is available in a traditional and a Roth account, which has different tax consequences than a traditional solo account.

The advantage of a solo Roth 401(k) is that even though you pay regular taxes on your money upfront, you can withdraw it tax-free in retirement. Whether a traditional or a Roth account is better for you depends on when you expect to have higher income taxes – now or later.

Unfortunately, the downside of these tax advantages is that you can’t access this money now without facing large tax penalties for withdrawing early. But it also helps compel you to truly save money for retirement, which is certainly a positive in my book.

Withdrawing Your Cash

Like fine wine, when you’ve aged enough you can open the bottle – or in your case, your retirement account. You can do this without tax penalties when you have hit the age of 59 1/2 (although there sometimes can be exceptions where you may withdraw earlier).

However, just because you can take withdrawals from your account doesn’t mean that you must or even that you should. But you must begin to take disbursements from your account by age 72.

If you need the money before you are 59 1/2 years of age, you can generally take a loan from your 401(k). But most financial experts, including me, don’t recommend this unless it is an absolute emergency.

If you withdraw your money early, you usually face a tax penalty of 10% in addition to the deferred taxes you must also pay. So withdrawing your retirement funds both hurts you in the future and is an expensive proposition in the present.

The more money you put into the account and the earlier you do so, the more time it will have to compound. I highly recommend that you contribute as much as you can to your retirement account starting right now.

A Few Other Features and Concluding Notes

One important point: Even though you can’t technically have any employees in your business other than you, your spouse is an exception. If they earn income from the business, your spouse can help you effectively double your annual contributions to your solo 401(k).

If you are self-employed and interested in opening an account, all you really need is an employer identification number (EIN). Find the available broker of your choice, fill out some paperwork and you will be able to start making contributions to your plan.

Everyone needs to be saving for retirement. It is one of the most important money moves you can make. No matter which type of retirement account is right for you, the sooner you start saving, the better.

If you are self-employed, a solo 401(k) can help you save money now so that you can have a truly flourishing retirement in your future. It’s simple: Save money now to win at life later.