Introducing the Solo 401k: The Perfect Retirement Account for Investors

A self-directed, or solo 401(k)—what the IRS calls a one-participant 401(k)—is a versatile retirement account perfect for investors and business owners. Prior to the solo 401(k), self-employed people didn’t have many options for retirement savings.

Born out of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the idea was to give self-employed entrepreneurs the opportunity to:

Grow retirement savings tax-free
Leverage a wider range of investments
Make higher contributions than with a traditional 401(k)
Invest in real estate

The high contribution limit and the ability to take deductions on both your business and personal taxes means you can use more of your money toward retirement. You can withdraw money from your solo 401(k) penalty-free after you turn 59 1/2. Withdrawals after age 59 1/2 are taxed as ordinary income. Withdrawals must begin at the age of 70 1/2—but this rule doesn’t apply if you go Roth-style.

Savvy investors can use the solo 401(k) to purchase tax-advantaged real estate and defer capital gains income. There are many ways the solo 401(k) can reduce your taxable income, but you’re also eligible for other perks like the Savers Credit.

Let’s take a closer look.

What Can I Invest In With a Solo 401(k)?

With a traditional 401(k), investments are limited to stocks, bonds, and mutual funds. The solo 401(k) lets you diversify your retirement dollars across nontraditional assets because it’s a self-directed account.

Account owners can invest in:

Precious metals
Renewable energy
Private placements (non-public offerings)
Foreign currencies
Real estate (stay tuned for more on this next week in my article “How to Invest in Real Estate With a Solo 401(k)”)

In fact, the IRS only prohibits three specific types of investments:

S-corporation stock
Collectibles
Life insurance policies

For many of my clients, the opportunity to invest in real estate is the primary reason they switch to a solo 401(k). Increased diversity and growth potential mean the returns can quickly escalate.

Who Is Eligible for a Solo 401(k)?

The solo 401(k) is great for consultants, freelancers, home businesses, and independent contractors. If you have a spouse, then he or she can also contribute to the plan. Partners or shareholders can be included in the plan, as well.

The solo 401(k) plan is available to anyone who is already a business owner or who will be establishing a sole proprietorship and does not have, or plan to have, full-time employees.

This basically means you should be the owner/operator of one of the following:

Sole proprietorship
LLC
C corporation
S corporation
Limited partnership

There’s no set amount of revenue for profit you should be generating. In most cases, the IRS will consider you eligible if your business is legitimate and run with the intention of generating profits.

You can be self-employed either part-time or full-time and even have another job somewhere else. You can also participate in an employer’s 401(k) plan alongside your solo 401(k). But if you choose to do this, your contribution limits will not be raised—so a few thousand dollars contributed to your employer 401(k) will mean a few thousand dollars less you can contribute to your solo 401(k).

Your company can have part-time employees who are excluded from the plan, as long as they meet one of the following conditions:

Under 21 years of age
Work less than 1,000 hours a year
Union employees
Non-resident alien employees

If you have full-time employees age 21 or older (other than your spouse) or part-time employees who work more than 1,000 hours a year, you will have to include them in any plan you set up. You can get around this by employing independent contractors. Otherwise, your solo 401(k) will have to be converted to a traditional 401(k) plan.

How to Set Up a Solo 401(k)

To fund a solo 401(k), you can rollover funds from previous retirement plans by setting up a trust account for the solo 401(k) and directly transferring your funds from the old custodian to the trust bank account.

Designate a trustee (usually you) to hold the solo 401(k) assets. To serve as trustee, you cannot legally benefit directly from the trust, enter into a transaction with the trust, or use the trust as your personal fund.

Since a solo 401(k) is an IRS-qualified retirement plan, it has to have a written 401(k) plan document that establishes how the plan works and operates. For example, the plan document will explain how you are able to borrow up to 50% or $50,000 (whichever is greater) from your solo 401(k) tax-free and literally for free. You pay interest, but the interest is paid into your account, so you’re really paying yourself.

How Solo 401(k) Contributions Work

The solo 401(k) plan accepts two types of contributions: salary deferrals and a profit-sharing contribution. Both are tax deductible and grow tax-deferred until withdrawals.

With a traditional 401(k), pre-tax dollars are taken from your wages and applied directly to your plan’s investments. Often, your employer will match this contribution.

Like an IRA or SDIRA, you can make traditional (pre-tax) or Roth (post-tax) contributions into a solo 401(k). A solo 401(k) also permits account owners to make a combination of employee deferral contributions and profit-sharing contributions.

The IRS regulates contribution limits for retirement and investment accounts. That limit is $5,500 each year for most accounts. A solo 401(k) has a maximum annual contribution of $54,000 for anyone under the age of 50.

Over the age of 50? The IRS lets you make “catch-up” contributions and increase your employee deferral contributions by $6,000. This means you can contribute $24,000 to your solo 401(k) instead of just the $18,000 allowed by the IRS for those under 50 years old. When combined with your profit-sharing contribution, this gives you a new maximum limit of $60,000 instead of $54,000.

If your company is a non-pass through entity, such as an S- or C-corporation, the IRS allows you to contribute 25% of your net W-2 income.

If you have a pass-through entity, such as a sole proprietorship or limited liability company (LLC), the IRS formula is much more complicated. Both the employee salary deferral contribution and the employer profit-sharing contribution are based on net adjusted business income—calculated by subtracting business expenses, as well as half of self-employment taxes from gross self-employment income.

To sum it up, unlike the self-directed IRA, the solo 401(k) has remarkably high contribution limits. While IRA contributions max out at $5,500 (or $6,500 for workers at the eligible age for catch-up contributions), you can contribute up $60,000 to your solo 401(k) if you’re under 50. If you’re over, you get an extra $6,000 allowance for catch-up contributions.

Can I Have Multiple 401(k) Plans?

Yes! If you still have a “day job,” you can have both a 401(k) account through your employer, as well as a solo 401(k) account through your side hustle. However, your total employee deferral contributions (for both plans) can not go beyond the $18,000 limit allowed by the IRS for those under 50 years old. And contributions to your solo 401(k) can only be made in relation to your self-employment activities. You cannot take money from your day job and contribute it to your solo 401(k).

However—the employer contribution to the 401(k) and your profit-sharing contribution to the solo 401(k) do not affect each other. In other words, if you make the maximum $18,000 contribution into your 401(k) account and your employer matches this, you have a total $36,000 contributions. Meanwhile, if your real estate business nets you a $200,000 income, you can contribute up to 25%, or $50,000, of this to your solo 401(k).

This gives you $86,000 in contributions you can use for investments!

6 Steps To Ensuring 401(k) Compliance

Step One: Update Your Account on Time

Updates are required by the IRS every six years. If you don’t update your solo 401(k), you’ll face costly fines and possibly even plan termination.

Step Two: Keep Track of Your Funds

Your income sources must be accounted for. At the very least, have a backed-up Excel spreadsheet.

Step Three: Separate Your Funds By Plan and Participant

If two people are contributing to one account, make sure they contribute from their own accounts. Also keep Roth accounts in their own space, separate from traditional funds.

Step Four: File a 5500 with the Department of Labor

You can opt for a 5500-EZ. This is, as you might suspect, an easy file version of a 5500. This has to be filed by mail. If you opt for a 5500-SF, you can do it online through the Department of Labor.

There are two situations that demand a 5500 for your solo 401(k). First, if you have more than $250,000; second, if you terminate a plan. You have to do this annually, so make sure you have enough money in the plan to make it worth it.

Step Five: Document Contributions and Rollovers

If you make contributions or roll over funds from an IRA or 401(k) into your solo 401(k), you need to state that the rollover is coming from another retirement account. The company rolling over the funds will issue a 109d9-R stating the source of the rollover so you don’t get taxed.

If you are making new contributions to a solo 401(k), track them on personal and business tax returns. If you’re an S-corp, employee contributions show up on your W-2 and your employer contributions will show up on your 1120S S-corp return—unless you are the sole proprietor, in which case your contributions show up on your personal 1040 (line 28).

To give you a sense of what is at stake, the penalty for not properly filing a 5500 is $25.00 a day to a maximum of $15,000 on your return. A mistake made on a filed return might keep you from retiring at all. See to the boring stuff. Get your paperwork done. Be up to date. The rewards are worth it.

Step Six: Avoid Self-Dealing

Your solo 401(k) can’t do business with you or any businesses you own. This is called “self-dealing,” and it’s against the rules because of the many obvious opportunities to bend the rules. Prohibited transaction penalties are something to look out for!

Questions? Comments?

Let’s discuss in the comment section below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.