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It's essential that all Americans have access to some kind of retirement savings account.
The government and IRS always need to support this access because Social Security distributions are not intended to be the total extent of one's retirement income.
For individuals employed by mid and large-size companies, investing for retirement is usually available to them through employer-sponsored retirement plans such as a 401(K) or 403(b) savings option.
That raises the question, “What are the available options for the self-employed small business owner?”
Actually, the U.S. Government, through the IRS, has made several retirement savings options available to those with self-employment income.
Two options are the Solo 401(k) and a Simplified Employee Pension IRA (SEP-IRA).
While both of these options have a substantial following among American small business owners, the Solo 401(k) advantages have made it a bit more popular.
With that in mind, the following discussion will focus on the Solo 401(k) retirement savings plan and how it works.
What is a Solo 401k?
The Solo 401(k) is also referred to as an individual 401(k), one-participant 401(k) plan, self-employed 401(k), or i401(k).
It's intended to serve as a retirement plan option for sole proprietors, freelancers, a one-member limited liability company (LLC), and other self-employed individuals with no employees or for entrepreneurs who employ only their spouses.
With an individual 401(k), you can invest in assets such as stocks, bonds, mutual funds, index funds, and exchange-traded funds.
And with a self-directed solo 401(k), you have alternative investment choices, such as real estate, cryptocurrency, peer-to-peer lending, and precious metals.
Unlike the SEP-IRA option, the Solo 401(k) for self-employed individuals acts much like an employer-sponsored 401(k) in that it allows for contributions from both the employee and the employer.
Of course, the employee and the employer are the same people in a business that a self-employed individual runs.
The point is the Solo 401(k) option allows for a higher level of contributions because of this employee/employer contribution provision. This means you can shelter employee earnings and business income from taxes.
How It Works: Solo 401(k) Contributions
It's important to re-stress that the Solo 401(k) allows for contributions from both the employee and the employer, acknowledging that both people are the same person, the self-employed business owner (except for an employed spouse).
At the employee level, the participant can contribute up to 100% of their “earned income” or net income to the plan. However, there is a statutory cap on employee contributions each year, and in 2022, that cap sits at $20,500.
Participants over 50 are permitted to contribute up to an additional $6,500 as a catch-up contribution.
A spouse who works for you and earns compensation also has the same employee contribution limit.
At the employer level, the annual profit-sharing contribution is set at up to 25% of the employee's earned income or $40,500.
Between the combined employee and employer amounts, the maximum contribution any participant can make is $61,000 in 2022, plus any portion of the $6,500 amount related to the over 50 catch-up provisions.
All contributions are usually made from pre-tax earnings (see Roth option below), making the contributions tax-deferred.
In other words, the participant will not have to pay taxes on the income they contribute until those monies are taken as distributions.
Note: Contributions can be made at any time during the tax year, including going into the next year until the individual files their tax return.
How It Works: Solo 401(k) Distributions and Withdrawals
As with a SEP IRA, participants can withdraw from their Solo 401(k) account at any time.
Yet, any distributions taken before the participant hits the age of 59 1/2 are subject to a 10% withdrawal penalty in addition to income tax payment on the distribution amount.
The tax rate for distributions is always the participant's individual federal income tax rate for the year or years they are taking distributions.
If, by chance, a participant needs to make a hardship withdrawal from their Solo 401(k) before the age of 59 1/2, there are circumstances under which the IRS will waive the 10% penalty provision.
These circumstances include:
- Having to pay a tax levy from the IRS
- To cover education costs for either the participant or a child
- For the purchase of a primary residence (limited distribution)
- Some emergency medical costs
- If the participant becomes disabled or unable to work (closing of the business)
Before the age of 72 (70 ½ if you reached that age before January 1, 2020), participants are not required to take any distributions. After that age, participants must start taking distributions (RMDs) to avoid a 10% penalty.
The IRS provides a calculation to determine the amount the participant will need to start taking in annual distributions over the age of 72.
Finally, the IRS does permit participants to borrow from their Solo 401(k) accounts. The borrowing limit is set at the lesser of 50% of the plan's net value, or $50,000.
The loan terms would be set at five years unless the loan was taken to purchase a primary residence. In that case, the participant would get a full 30 years to repay the loan.
Interest is charged on Solo 401(k) loans, but the participant is simply required to pay the interest directly into their Solo 401(k) account.
The applicable rate will be determined when the loan is taken. Any amounts not paid back on time would be treated as distributions and subject to applicable penalties and income taxes.
Types of Solo 401(k) Accounts
Prospective Solo 401(k) participants can choose between one of two types of accounts. One is the Traditional Solo 401(k), and the other is the Roth Solo 401(k).
What differentiates these two options is how the participant's tax liability will be handled.
Traditional Solo 401(k)
The Traditional option follows the process described previously.
The contributions are made with tax-deferred income, therefore, reducing your taxable income. Taxes are paid in the future when distributions are taken.
Roth Solo 401(k)
The Roth option requires that contributions be made from monies already taxed.
With this option, there's no tax liability when “tax-free” distributions are taken. The great advantage of the Roth option is all investment earnings are also “tax-free.”
Benefits Derived From Choosing the Solo 401(k) Option
As we mentioned above, the Solo 401(k) option is much preferred by self-employed persons because of its advantages.
Those benefits include:
- Deferring taxes on traditional contributions until the money is taken as a distribution
- Generous contribution limits
- Contributions can be made by the employee and employer (employer profit-sharing contributions)
- Roth Solo 401(k) option allows for “tax-free” investment earnings
Which is better – a Solo 401k or a SEP IRA?
For you, this decision would boil down to whether or not your business has substantial earnings.
If your annual combined contributions exceed the statutory contribution level set by the IRS, either of these options would be okay because most features are the same.
If your annual contribution consistently falls below the IRS contribution limit, the Solo 401(k) would be a better choice.
The employee/employer provision associated with the Solo 401(k) option would allow you to contribute more each year. The Sep IRA only allows employee contributions.
If and when you're ready to open your own individual 401(k) retirement savings account and reap the tax advantages, you may do so through a bank, retail brokerage account, or online investment account.
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