How does a Solo 401(k) plan work?

by | Jul 28, 2022 | Business Planning | 0 comments

The 401(k) is one of the most well-known retirement vehicles out there. And as an employee, it’s a fantastic way to take advantage of compounding returns and create a life of financial freedom. But what about on the employer side of things?

Unfortunately, that’s where things get a bit murkier. All too often solopreneurs aren’t aware of the retirement options at their disposal. And with all of the responsibilities already on their plate, it’s easy for their own retirement planning to take a back seat. But that’s a mistake!

As a firm that specializes in helping business owners, we see firsthand the impact that specialized retirement accounts can have on their lives. For solopreneurs that account often comes in the form of a solo 401(k). So in this article, we’re going to discuss what a solo 401(k) is, what benefits it offers, and how solopreneurs can begin leveraging its power.

What is a Solo 401k Plan?

A solo 401(k) is a type of 401(k) that’s specifically made for business owners who don’t have employees. In fact, by IRS rule, you cannot invest in a solo 401(k) if you have any full-time workers (other than a spouse).

Similar to a regular 401(k), a solo 401(k) earns money based on the investments to which it’s tied. These investments are typically mutual funds or target-date funds that consist of an assortment of stocks and bonds based on your choosing.

Also like a regular 401(k), and other individual retirement accounts (IRAs), a solo 401(k) comes in both traditional and Roth varieties. This makes a substantial difference come tax time, which we’ll touch on in the next section.

Benefits of a Solo 401k Plan

1. Tax-sheltered withdrawals and contributions: With the Roth option, you can contribute to your solo 401(k) with after-tax dollars. You’ll then be able to withdraw your retirement funds tax-free. However, with a traditional variant, you’ll instead be able to deduct your solo 401(k) contributions, grow your money tax-deferred, then pay ordinary income taxes on your withdrawals.

2. Flexibility: Solo 401(k)s offer you options. They come in both Roth and traditional formats, which gives you the choice of how you want your contributions to be taxed.

3. Contribute as an Employee and Employer: Additionally, solo 401(k)s allow you to contribute on one side as an employee, and from another side as with an employer match. This dualistic contribution isn’t available with other retirement vehicles like Self-Directed IRAs.4

4. Higher contribution limits: Solo 401(k)s, which allows for greater tax-advantaged saving. For 2022, you can contribute up to $61,000 as long as your contributions meet IRS requirements. And for those 50 or older, you’ll be able to make an additional $6,500 in catch-up contributions.

5. Borrowing advantages: With a solo 401(k), you’re allowed to borrow up to $50,000 or 50% of your account balance (whichever is less), and the money can be used for any purpose, including investments in real estate. And unlike IRAs, your solo 401(k) borrowings can be used to buy real estate without having to pay the unrelated business taxable income (UBTI) tax!

Solo 401k Rules and Guidelines

First, you have to be a business owner with no full-time employees. However, it’s worth noting that if you employ a spouse, you can still use a solo 401(k). Both you and your spouse can be covered by it.

As far as opening a solo 401(k) goes, there are no age or income restrictions. But there are contribution limits that will vary depending on IRS rules as well as your personal age(s). If, for example, you are over the age of 50, you’ll be able to make even greater “catch-up” contributions.

When it comes time to make withdrawals, you’ll want to be 59 ½ or older. Taking out money before then comes will invoke taxes and penalties. Aside from a few exceptions, these early withdrawals will be subject to a 10% tax penalty. Even with a Roth solo 401(k), you’ll still end up paying otherwise avoidable taxes if you make withdrawals prematurely.

By April 1st of the year you turn 72, you will be required to start making withdrawals from solo 401(k). These are known as required minimum distributions (RMDs). However, if you have a Roth solo 401(k), you can roll over the assets into a Roth IRA, which is free from RMDs.

How to Set Up a Solo 401k

You can set up a solo 401(k) through most online brokers (ex: Charles Schwab). Keep in mind when doing so, you’ll need to have your Employer Identification Number (EIN).

The broker you go through will have an assortment of options to choose from including, but not limited to index funds, mutual funds, and exchange-traded funds. You’ll also be able to set up a vesting schedule through your broker. This will include the amount and the timeframes for your contributions.

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How Can Vertical Wealth Management Help You?

At Vertical Wealth Management, we specialize in helping business owners secure their financial futures. And for our solopreneur clients, this often involves taking advantage of solo 401(k)s for their retirement.

Deciding what investments to tie your solo 401(k) is tough. You have to have a firm understanding of where you are, where you’re looking to go, and what risks you’re willing to take along the way.

Through our ongoing consultative relationships, we help our business owner clients do just that. We help them develop a portfolio that aligns with their values and visions of the future. And we adjust that portfolio whenever new life circumstances deem it necessary. Schedule your free consultation call today, and start your retirement planning off on the right foot.