If you’re self-employed, you can use a 401(k) to boost your retirement savings. Here’s what you need to know.
Solo 401(k) Overview
A self-employed 401(k) is commonly called a solo 401(k). That’s because you’re opening a 401(k) by yourself.
A solo 401(k) or self-employed 401(k) is the same as a regular 401(k) you can get through an employer. You get the same tax benefits, and your investment options are often better since you get to pick where to open your self-employed 401(k).
The main difference between a solo 401(k) and regular 401(k) is paperwork. Since there are no employees to worry about, there’s a lot less paperwork for a solo 401(k). That makes it a lot easier to open one and means more brokers offer 401(k) options.
Self-Employed 401(k) Contribution Limits
You can contribute to a self-employed 401(k) as both the employer and employee.
Employee Contributions
As the employee, you get the regular 401(k) limit. That’s $22,500 in 2023.
If you have a 401(k) from another job, the employee limit is for all of your accounts not per account. Make sure you get any employer match then contribute to whichever account has better investment options.
Note: If your self-employment work is a side hustle, there’s a separate rule where you can’t contribute more than 100% of your compensation to your 401(k). That’s usually your net profit minus 1) 50% of your self-employment tax and 2) your 401(k) contribution.
So don’t just contribute all the money you receive for your work. You have to subtract your business expenses plus those two adjustments above.
Employer Contributions
As an employer, you can generally contribute 20% of your net profit adjusted for one-half of self-employment tax.
This is lower than the 25% of compensation employers can usually contribute for employees because your own 401(k) contribution reduces your net profit for 401(k) purposes.
The employer limit is separate from the employee limit, but the most you can put into your 401(k) combined is $66,000 as of 2023.
Deadline to Open a Self-Employed 401(k)
The deadline to open a self-employed 401(k) is generally December 31st. You need to complete the opening process by then but generally have until your business tax return is due to put money in.
Reminder: S-corporation and partnership tax returns are due March 15th rather than April 15th. (This may vary if you don’t use the calendar year as your tax year.)
You don’t have employees, right?
If you have employees, you can’t open a solo 401(k). Solo means one worker. It’s not like sole proprietorship where sole means one owner who may or may not have employees.
The only exception is that you can include your spouse in a solo 401(k). Of course, your spouse actually needs to be working in your business.
If your spouse doesn’t work, check out a spousal IRA.
If you have employees, you’ll need to find a small business 401(k) provider. These are still usually fairly inexpensive but will have more administrative fees than a solo plan.
Talk to your accountant about the rules for employer contributions when you have employees. Basically, you can’t give yourself big employer contributions but not give your employees a similar 401(k) match.
Traditional and Roth Self-Employed 401(k)
Like a regular 401(k), you can choose to make your employee contributions to either a Traditional 401(k) or Roth 401(k). You can also split your contributions between both types of accounts.
The employer portion of your contributions always goes into your Traditional 401(k).
A Traditional 401(k) gives you a tax deduction for your contributions, and you pay income taxes on your withdrawals in retirement. A Roth 401(k) lets you make non-deductible contributions so you pay taxes now and then don’t pay taxes when you withdraw money in retirement.
Having a Self-Employed 401(k) and an IRA
You can still have an IRA if you have a self-employed 401(k). You still get your full IRA contribution limits just like you do when you have a 401(k) in a salaried job.
Having a self-employed 401(k) can affect whether your IRA contributions are deductible.
- If you don’t have any kind of employer plan, there is no income limit on deducting IRA contributions.
- If you have an employer plan, including a solo 401(k), the income limits for deducting your IRA contributions apply.
If your income is too high to deduct an IRA and you want the maximum deduction, max out your 401(k) first.
SEP IRA versus Solo 401(k)
A SEP IRA is a popular alternative to a self-employed 401(k). A SEP IRA allows you to contribute as an employer but not as an employee.
So you lose the $22,500 individual contribution but can still contribute 20% of your compensation. For many people, 20% is enough.
Compared to a solo 401(k), a SEP IRA:
- Is offered by more brokers
- Is slightly easier to open
- Has less annual paperwork
- Usually comes with lower administrative fees (but that difference is shrinking these days)
- Has more early withdrawal exceptions such as a down payment on your first home
- May have less protection against creditors depending on the state you live in
- Can be opened as late as your tax filing deadline
Choosing a Self-Employed 401(k) Provider
When you’re looking for a solo 401(k) provider, keep these things in mind:
- Does it have a Roth option?
- Does it support adding your spouse?
- Does it support 401(k) loans?
- How does it handle 401(k) hardship withdrawals?
- Setup fees (many don’t have any)
- Account maintenance fees (many don’t have any, you may need a minimum balance or recurring contribution to waive fees)
- Investment options (types and fund fees)
- Trading costs
- Robo advisor fees
- Broker stability — having your broker go out of business or get bought out can create major hassles. So can having to switch because of changes in fees or investment options.
- IRS reporting (do they send the annual forms for you?)
Vanguard, Charles Schwab, and Fidelity are popular options with generally positive reviews.
I would stay away from the big banks like Bank of America or Chase due to fees and limited investment options. Use a regular IRA or taxable brokerage account if you’re trying to meet minimum balance requirements.
