3 Rules for a Solo 401(k) for Effortless Savings.

If you’re considering consulting work or starting a business it can be very rewarding financially. As your earnings increase you may start to think about how to save for retirement. The numerous options can be overwhelming resulting in inaction.

I will focus on the solo 401(k) here. The plan is not as well covered in my opinion. A solo 401(k) is a little tricky to navigate and set up. That said, there are some pretty sweet advantages if you do a little planning.

Plan Set-Up

IRS Rules (Boring I know, but necessary): The IRS requires that you’re a business owner with no employees. This is the major hang up for the plan. The rules do allow for an account to be set up for the owner’s spouse. This is something to keep in mind. It is typically the best choice if you are self-employed, or a single owner C-Corp or S-Corp. You can usually put back more money. Most people think a SEP is the better choice, but this is not always the case. The deadline to set up and make contributions to solo 401(k) is the extended due date of your business tax return for the current year. If you accumulate above $250,000 in the plan you must file a form 5500 with the IRS. If you have a CPA it’s a fairly straight forward process. Typically it doesn’t require a lot of extra work or money.

Adoption Agreement and Summary Plan Description: Custodians like TD-Ameritrade can assist in opening a solo 401(k). The accounts will be held with them, as they have custody over the assets. They require a few documents on the front end. These include an account opening form, adoption agreement, and the summary plan description. The later two state the plan rules and features. We use TD-Ameritrade and they do a great job at guiding you through the process. This is a service I provide to help people set up and manage their retirement plans.


Investment Options: A major benefit of a solo 401(k) are the investment options. An open platform like TD-Ameritrade has additional investments to choose from. You aren’t confined to ten or twenty funds that is typical of a traditional 401(k) plan that can result in higher fees. Options can include mutual funds, ETFs, stocks, and bonds. No transaction fee ETFs and load waived mutual funds are available.

Plan Loans: You can allow for plan loans. The amounts can vary depending on the balance of the account. Interest usually accrues at the applicable federal rate. This is a minimum rate set by the IRS. I will say, this should be used as a last resort effort for funds. Your financial plan should be well rounded. Planning for life’s unexpected events with adequate savings and cash flow management is important. That said, emergencies do happen and this can provide comfort.


Elective Deferrals and Employer Nonelective Contributions: As a business owner, or self-employed person, you act as both the employer and the employee. You may elect to stop deferrals during leaner years when you don’t have the cash flow for contributions. This is an added layer of flexibility. You can elect to defer 100% of compensation/earned income for a maximum of $19,500. A $6,500 catch up is allowed if you are over age 50 making for a total deferral of $26,000. The employer “matching” component is a non-elective contribution of 25% of compensation.

The 25% applies to earnings of $285,000 or below for 2020. The maximum one can contribute total to the plan is $57,000 or $63,000 if you’re 50 or older. Self-employed people have to go through a different calculation for the match. This is due to account for self employment taxes and plan contributions. Check with your CPA to arrive at this number. I ballpark the number at 20% of earned income for planning purposes.

Example: If you’re 40 years old, paid a W2, and make $100,000 you can defer up to $19,500 with an additional $25,000 for the match totaling $62,500. As a side note, a SEP would only allow you to contribute the $25,000.

Roth Contributions: Solo 401(k)’s allow you to make Roth contributions. These are after-tax contributions that grow and are withdrawn tax free. This is in contrast to regular contributions that are pre-tax. Pre-tax contributions are free from federal income taxation when contributed but not FICA tax. They are taxed as income once withdrawn. The Roth component can generate large tax savings over time. Having all three types of accounts– After tax investment accounts, Traditional IRAs, and Roth IRAs–can provide tax diversification, since we don’t know what will happen with the tax code in the future.

Spousal Account: An account can be set up for your spouse, as I stated earlier. This can potentially double the amount you put back. If each of you are saving $62,500/year for a total of $125,000 and we assume a 8% rate of return over 15 years this results in almost $3.4 million in retirement savings. Now we’re talking! At this point you can really begin to think about financial independence.

If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNERâ„¢ at Applied Capital. Email him at [email protected]

This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.

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