What is a Solo 401(k)?

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You've done the market research, you've counted the cost, and your business finally has some profits. Congratulations! That is no easy task. But there may be one thing you still need to consider: retirement.

There are a lot of options to consider when it comes to retirement accounts. The most common small business retirement accounts are the SEP IRA and the SIMPLE IRA. However, if you are a one-person business, one option with significant benefits is a solo 401(k).

What is a solo 401(k)?

To put it simply, a solo 401(k) is a retirement plan designed for business owners who have no employees. There are a few things that set it apart from a regular 401(k) plan, including contribution limits and flexibility regarding investment options.

Who can get a solo 401(k)?

There are only two eligibility rules when it comes to the solo 401(k):

  1. You cannot have any other employees other than yourself and your spouse.

  2. You must have an Employer Identification Number (EIN) with the IRS.

One thing to keep in mind is your future vision for your business. For example, do you plan to hire full-time employees in the future? Do you want to bring on partners or investors? Do you want to build the largest oyster restaurant in the Midwest? If your answer to those any of those questions is "yes," then you may want to consider other retirement plans.

What are the contribution limits?

Someone under the age of 50 with a solo 401(k) can contribute up to $66,000 in 2023 (or $73,500 for age 50 or older). Before you get too excited, let's look at some of the caveats.

There are two ways you contribute to a solo 401(k). First, you contribute as an employee of your business. The second way is through the profit-sharing component. This will take some explaining, so bear with me.

Just like a regular 401(k), you can contribute up to the lesser of $22,500 (2023) or your total compensation. In other words, the amount you pay yourself must be $22,500 or greater to contribute the full amount. If you're over 50, you can also contribute an additional $7,500, for a total of $30,000.

Next, you'll need to determine the amount for the profit-sharing component. This is more complicated to determine since it will depend on how you structure your business (sole proprietor, LLC, S corp, etc.). I won't get into the precise formula here, but it comes out to either 20% of net adjusted business profits or 25% of W2 earnings.

That said, there is a limit on the amount of compensation you can use for calculating the profit-sharing component. For 2023, you can use up to $330,000 of compensation for calculations. 

Sound a little complicated? It is. Make sure you consult with a professional to determine the profit-sharing contribution. You can also find more information through IRS Publication 560.

*NOTE: The employee contribution limit applies to ALL 401(k) plans in your portfolio. This means if you have a day job with a 401(k) plan, you cannot max out both plans.

What if my spouse also earns money from my business?

Your spouse is the only exception to the no-employee rule. If your spouse earns income, he or she has the same contribution limits as you. Furthermore, the same profit-sharing rules also apply. This means you could potentially double the amount you contribute, depending on your income.

Any tax advantages?

No retirement plan is complete without tax advantages. With the solo 401(k) you have two options: Pre-tax contributions (Traditional) and after-tax contributions (Roth).

To break it down a little further, pre-tax contributions are those made before you take out any taxes from your paycheck. This money goes directly to your 401(k) and is invested. The investments grow tax-free and then you pay taxes on the distributions. This method also reduces your taxable income for the year, so it is ideal for high earners or for those who think they will be in a lower tax bracket in retirement.

After-tax, or Roth, contributions are the opposite. This is money on which you've already paid taxes. Therefore, the money grows tax-free and you get tax-free withdrawals during retirement. This is a great option for those who earn less or who think they will be in a higher tax bracket in the future.

Also, note that the 401(k) is designed for retirement. If you make withdrawals before 59 and 1/2, you will get hit with a 10% penalty from the IRS.

Can I control my investment options?

With a regular 401(k), your employer selects the investment options. However, with the solo 401(k) is that you're also the employer. This means you have full control over your investment options.

How do I get started?

The solo 401(k) is a great opportunity for any solo entrepreneur with high earnings. Without a doubt, it can help a solo entrepreneur continue to live generously and invest in Kingdom-building activities during retirement.

Before you jump into a solo 401(k), I recommend talking with a financial professional. A great place to start would be to talk with a Kingdom Advisor in your area. These are financial professionals who care about helping you honor God in your financial decisions. Make sure you have someone on your side who can take a look at your situation and make a solid recommendation.

About the author: Jon Matlock serves as a financial planner at American Financial Planning, Inc. in Roanoke, Virginia. He is a CFP® candidate, a professional member of Kingdom Advisors, and a graduate of Southeastern Seminary. Before pursuing financial planning, Jon served overseas with the International Mission Board and also worked in their Church Success Center. In his free time, Jon enjoys serving his church, hiking in the beautiful Roanoke Valley, and spending time with his wife and son.