A Solo (also known as an individual or one-participant) 401(k) plan is a 401(k) plan available for small businesses with no employees except for the business owner and his or her spouse if the latter participates in the business. In general, a Solo 401(k) plan has pretty much the same rules as a traditional 401(k). With that being said, many small business owners falsely believe that setting up and administrating one can become a real pain in the neck. Nothing could be further from the truth. There are some important distinctions that not all business owners are aware of that make a Solo 401(k) plan an incredibly valuable retirement vehicle.
Let’s look into the important features of Solo 401(k) plans including the commonalities between Solo and traditional 401(k) plans.
Easy to Establish and Low Set-Up Fees
A Solo 401(k) needs to be established by December 31st of the year in which you would like to get the tax deduction. All you need to do is adopt a written plan, communicate to the employees (which is either yourself or you and your spouse), and invest the assets. Obviously, there are no eligibility restrictions.
In terms of set-up fees, which are a big concern for many business owners, Solo 401(k) plans are very inexpensive to set-up and maintain. There are many financial providers that can establish a Solo 401(k) for free.
High Contribution Limits
Like traditional 401(k) plans, Solo 401(k) plans offer high contributions limits. By being a small business owner, you act as both an employee and an employer, meaning that you can make contributions in both capacities. Since both contributions are tax deductible you can significantly minimize your tax liability.
As an employee, you can contribute up to 100% of your annual compensation, but no more than $18,000 for 2017. If you are older than age 50, an additional $6,000 catch-up contribution can be made.
As an employer, you can contribute up to 25% of your annual self-employment income for incorporated business, or up to 20% of net earnings for the year from self-employment for unincorporated income.
Subject to the IRC Section 415(c) limits, annual additions to an employee-participant’s plan account cannot exceed the lesser of $54,000 in 2017 or 100% of your annual compensation. If you are older than age 50, an additional $6,000 is permitted.
Like IRAs, employer contributions to a Solo 401(k) plan for the previous year can be made before the Federal tax filing deadline, giving you additional flexibility to balance the books.
Discretionary Contributions
Both employer and employee contributions are non-discretionary. Depending on your business needs and financial situation, you can stop making contributions and reallocate the funds towards your business.
Simplified Reporting
Traditional 401(k) plans are required to file Form 5500 annually. However, a Solo 401(k) is not obligated to do that until total plan assets exceed $250,000. Only after plan assets exceed $250,000, you are required to file Form 5500-EZ at the end of the year.
In addition, you are not required to report employer contribution on a W-2.
No Discrimination Testing
Technically, Solo 401(k) plans are not governed by ERISA. What that means is there is no discrimination testing requirement. Discrimination testing is a very time consuming and expensive thing to do. Given that important advantage, administration of a Solo 401(k) plan is in fact much simpler than many small business owners believe.
Additional Features
Like traditional 401(k) plans, Solo 401(k) plans allow for loans and hardship withdrawals. While we are not big supporters of these features and tapping into a retirement nest egg, there are some life situations where you may need access to your retirement funds.
Another great feature of a Solo 401(k) plan is the ability to have a designated Roth account. A designated Roth account is a separate account within your Solo 401(k) plan which accepts after-tax employer contributions. All qualified distributions from a Roth account are not included in your taxable income, but they are subject to required minimum distributions.
Finally, participation in other retirement plans is allowed. For example, if you have a second job that offers a 401(k) plan, nothing prevents you from participating in both. However, it is essential that your track your total contributions. The annual IRS contribution limit of $18,000 is for both plans, not each plan separately.
Conclusions
A Solo 401(k) plan is an extremely valuable retirement vehicle that has the same contribution limits and tax advantages as a traditional 401(k) plan, but at just a fraction of the cost of a traditional 401(k) plan. As we’ve shown above, many prejudices that were associated with Solo 401(k) plans are inaccurate.
They are very easy to establish and can be set up for free. Solo 401(k) plans are easy to administer and have simplified reporting with minimum paperwork. Moreover, numerous Solo 401(k) providers can supply all of the necessary administrative support for a reasonable annual fee, if not for free.
Another important advantage of a Solo 401(k) plan is that it provides access to an unlimited number of investments. This is not the case for traditional 401(k) plans where investment options are limited to a predetermined set of investment funds. This investment flexibility has two benefits: you can build a more diversified investment portfolio, and minimize investment expenses by choosing low-cost index ETFs.
If you are a small business owner with no common-law employees, a Solo 401(k) plan is perhaps the best, and not to exaggerate, the most unique retirement savings vehicle that you can’t ignore. So why not give it a shot?