Every few months, it seems, yet another study comes out warning that Americans aren’t saving enough for retirement. Each study is followed by a flurry of tsk-tsking articles urging people to put more money into their 401(k) plan or other workplace retirement plan. That’s sound advice for most people, but for freelance workers, it’s not much help.
If you’re self-employed, investing in a workplace plan isn’t an option. You can put money into an IRA or Roth IRA, but there are fairly low limits on how much you can save this way. For 2021, the annual contribution limit is $6,000. If you make $75,000 per year, that’s only 8% of your income about half of the 15% many experts say you should sock away each year.
Fortunately, there’s another retirement option for self-employed people that’s not as well-known: the solo 401(k). These plans, which can be set up through a company like Rocket Dollar, allow you to save more of your income tax-free than an IRA or Roth IRA, but they’re a bit more complicated to set up and use. Here’s how the solo 401(k) works and how to decide if it’s the right plan for you.
How a Solo 401(k) Works
The solo 401(k) is just what it sounds like: a 401(k) for one person. It’s also known as a one-participant 401(k), solo-k, or uni-k. These plans work just like any other 401(k) plan, but with a twist: You are both the “employer” and the “employee.” That means you can contribute more to a solo-k than you could as an employee with a regular workplace plan.
Tax Advantages of a Solo 401(k)
Like a workplace 401(k), a solo-k allows you to set aside retirement savings out of your pre-tax income. This reduces your taxable income, so you pay less income tax. The money in your solo 401(k) account continues to grow tax-free until you reach retirement age. When you start withdrawing money from your account in retirement, it’s taxed just like regular income.
For example, suppose your self-employment income is $60,000 per year. Assuming you take the standard deduction ($12,200 for a single person), your federal income tax on this amount comes to about $4,440. However, if you set aside $6,000 of this income in your solo 401(k), your taxable income drops to $54,000. This reduces your tax bill to roughly $3,720, saving you more than $600 in taxes.
While contributing to a one-participant 401(k) reduces your income tax, it doesn’t affect your self-employment tax, which is the amount you must contribute each year toward Medicare and Social Security. Currently, this tax comes to 15.3% of all the business income you earn from self-employment. So even if you reduce your taxable income by $6,000, you must still pay self-employment tax on the full $60,000.
There’s also a version of this plan called a Roth solo 401(k). The tax benefits of this plan work in reverse: You fund the plan with after-tax dollars, but you pay no taxes on the money when you withdraw it in retirement. If you expect your income in retirement to be higher than it is now, you’ll save more overall by choosing the Roth plan. However, if you think your income will fall, you’re better off with the traditional version.
If you participate in a workplace 401(k), you can make plan contributions for yourself, and your employer can make matching contributions on your behalf. With a solo 401(k), you can contribute as both an employer and an employee. There are separate limits on how much you can contribute in each role. These are the limits as of 2021:
- Employee Contribution. As an employee, you can make elective deferrals of up to $19,500 per year or 100% of your income from self-employment, whichever is lower. In addition, if you’re at least 50 years old, you can make an extra “catch-up” contribution of $6,500, raising your total limit to $25,000.>
- Employer Contribution. As your own employer, you’re allowed to contribute up to 25% of your earned income. Earned income is defined as your net earnings from self-employment after deducting the amount you’ve already contributed to the plan as an employee and half of your self-employment tax. For instance, suppose you earned $60,000, made the maximum employee contribution of $19,500, and paid $9,180 in self-employment tax. In this case, your earned income would be $35,910, and your maximum employer contribution would be $8,977.50.
In most cases, the total amount you contribute to your solo-k — as both an employer and an employee — can’t be more than $58,000. If you’re 50 or older, this limit goes up to $64,500 on account of the catch-up contribution.
All of these limits on your contributions — as an employer, an employee, and in total — apply to all of the money you contribute to any 401(k), not just your uni-k. This rule comes into play if you have a regular job that has its own workplace 401(k) but you also earn money from a side gig. You can set up a solo-k for your freelance earnings, but your total contributions to both plans combined must stay within the limits.
Tax laws limit not only how much you can contribute to a solo 401(k), but also how long you can go on contributing. When you reach age 72, you must stop putting money into your solo-k and start taking money out. The amount of money you must withdraw from your account in a given year is called the required minimum distribution, or RMD. The IRS provides an IRA Required Minimum Distribution Worksheet to help you figure out yours, or you can use an online RMD calculator. (All RMDs for calendar year 2020 were waived as part of the CARES Act, but the requirement resumes in 2021.)
The solo 401(k) is available only for self-employed people who have no other employees, such as independent contractors. If you’re a small-business owner with multiple employees, you must set up a retirement plan that covers them as well. If you’ve already set up a one-participant 401(k) for yourself and you then decide to hire employees, you’ll need to add them to your plan, turning it into a regular workplace 401(k).
However, there’s one exception to this rule. If you’re married and your spouse also earns income from your business, you can both participate in the same solo 401(k). Doing this basically doubles the amount you can contribute as a couple. Each of you can contribute up to $19,500 as an employee (or $26,000 if you’re over 50). Then, as the employer, you can contribute up to 25% of earned income for you and 25% for your spouse. All told, you can sock away up to $58,000 for each of you, or $116,000 combined.
Participating in a solo 401(k) makes your taxes more complicated than contributing to an IRA. When you put money into an IRA, you can simply list it on Schedule 1 of your Form 1040. If you’re self-employed, you have to file Schedule 1 anyway, so this doesn’t make any more work.
However, if you have a solo 401(k) with more than $250,000 in assets, you must file a report on its earnings each year using Form 5500-EZ. This form isn’t part of your regular annual tax return; you must fill it out and file it separately. You can submit the two-page form either online or by mail. (The three-page Form 5500-SF is no longer used for solo 401(k) plans started after Jan. 1, 2020.)
Form 5500-EZ requires information about you, the amount of money in the plan, how much money went into it in the past year, how much it earned, and various technical details about investments in the plan. Tax software such as TurboTax doesn’t include this form, so you’ll probably need the help of an accountant to complete it. If you don’t already use an accountant for your taxes, this will add to your expenses.
The Solo 401(k) vs. Other Retirement Plans
Although the one-participant 401(k) is specifically for self-employed people, it isn’t the only kind of retirement plan you can use if you’re self-employed. There are lots of other plans you can choose from, including traditional and Roth IRAs, SEP and SIMPLE plans, and defined benefit plans. Each type of plan offers a different set of pros and cons. Here’s how the solo 401(k) stacks up against the alternatives.
A traditional IRA offers basically the same tax benefits as a solo 401(k); you fund it with pre-tax dollars, then pay taxes when you withdraw the money. With both types of plan, you typically can’t touch the money until you reach age 59½. If you withdraw anything from your plan before then, you pay taxes on it immediately, as well as a 10% penalty. There are some exceptions to this rule if you’re withdrawing the money for specific financial needs, such as medical bills, college tuition, or the purchase of a house. And like a solo 401(k), a traditional IRA requires you to start taking RMDs at age 72.
The main advantage of a solo 401(k) is that it allows you to save a lot more of your pre-tax earnings. Going back to the earlier example, if you make $60,000 per year, a solo-k enables you to contribute up to $19,500 as an employee and $8,977.50 as an employer. That’s a total of $28,477.50 — about 47.5% of your income. By contrast, with a traditional IRA, you can contribute only $6,000 — just 10% of your income.
If you’re just starting out as a freelancer, this isn’t necessarily a problem. When you’re barely managing to make ends meet, you probably can’t afford to contribute more than $6,000 per year anyway. However, the more you make, the more limiting that $6,000 cap becomes.
On the plus side, traditional IRAs are very easy to set up and maintain. Any investment firm can create one for you, or you can set one up at an online brokerage in just a few minutes. And, as noted above, there are no special tax forms to fill out.
The Roth IRA, like the Roth version of the solo 401(k), turns the tax benefits of a traditional IRA upside down. You fund the account with after-tax dollars, but you pay no taxes when you withdraw the money in retirement. You can also choose to leave your money in the account indefinitely; there are no RMDs.
The contribution limit for the Roth IRA is $6,000 per year, the same as for the traditional IRA. Both plans allow an extra $1,000 catch-up contribution for people over 50. Also, like a traditional IRA, it’s easy to set up and has no special reporting requirements.
However, unlike a traditional IRA, the Roth IRA has an income limit. For tax year 2021, if your income is over $125,000 (or $198,000 for a married couple), you can’t contribute the full $6,000 per year. If it’s more than $140,000 ($208,000 for a couple), you can’t use a Roth IRA at all. That makes the solo 401(k) a more attractive option for high earners.
The Simplified Employee Pension (SEP) plan is a retirement plan for self-employed people and small businesses. Under this plan, you set up a separate retirement account, known as a SEP IRA, for each of your employees, including yourself. A SEP is easier to set up and maintain than a solo 401(k). You can create one at any investment firm, and you don’t have to file any annual reports.
One big difference between this account and a solo-k is that you can use a SEP if your business has employees aside from your spouse. However, if you do this, you must contribute to your employees’ accounts as well as your own. For example, if you put 10% of your salary into the SEP, you must also put in 10% of each eligible employee’s salary. “Eligible employees,” in this case, doesn’t just mean full-time employees. Any employee who’s at least 21 years old, made at least $600 working for you last year, and has worked for you for at least three of the last five years must receive benefits from the plan.
With a solo 401(k), you can contribute as both the employer and the employee. With a SEP IRA, you contribute as the employer only. That means the most you can contribute to your own plan is 25% of your earnings, up to a maximum amount of $58,000.
Some SEP plans allow you to also make non-SEP contributions, including catch-up contributions, to your own SEP IRA as if it were a normal IRA. However, these contributions are all subject to the $6,000 maximum for IRA contributions.
The Savings Incentive Match Plan for Employees, or SIMPLE IRA, is another type of retirement plan for small businesses (those with up to 100 employees). Like a traditional IRA, a SIMPLE IRA is funded with pre-tax dollars and taxed in retirement. This type of plan also has the same limits on withdrawals as a traditional IRA. You can’t withdraw any money before age 59½ without paying a penalty, and you must take RMDs starting at age 72.
Unlike the SEP IRA, the SIMPLE IRA is funded by both the employer and the employee. The maximum any employee (including you) can contribute is $13,500, plus a $3,000 catch-up contribution for those ages 50 and up.
On top of this, the employer (you) must provide matching contributions for employees. Typically, you must match donations up to 3% of the employee’s earnings, up to a maximum salary of $290,000. Alternatively, you can choose to contribute 2% of each employee’s salary, whether the employee contributes or not.
All in all, a SIMPLE IRA allows you to save more of your pre-tax income than a traditional or Roth IRA, but less than a solo 401(k). On the plus side, this type of plan is fairly easy to set up; it’s basically like creating an IRA for each employee. You also don’t have to file Form 5500 for this type of plan.
Defined Benefit Plan
A final option is a defined benefit plan, or pension. This type of plan is funded by the employer (you, if you’re self-employed), and it gives the employee (that’s you again) a fixed income in retirement. Like most retirement plans, it’s funded with pre-tax dollars and taxed in retirement. You generally can’t make any withdrawals from it before reaching age 62, and you must start taking RMDs at age 72.
A defined benefit plan allows you to contribute more of your pre-tax income than any other type of plan. You can contribute up to 100% of your average earnings for the past three years, up to a maximum of $230,000. That means you could effectively shelter your entire income from taxes this way.
This type of plan is available to businesses of any size. However, if you have employees, you must contribute to the plan for all of them. Since this type of plan is entirely employer-funded, that can get very expensive.
Even if you’re a sole proprietor with no other employees, this plan has some major drawbacks. It’s much more complicated — and therefore more expensive — to set up and maintain than most other types of plans, and only a few brokerages offer it. Also, once you set up the plan, you must fund it fully every year; if you change your contribution amount, you must pay a fee. And it requires you to file Form 5500 each year.
Overall, this type of plan is most useful for freelancers with very high incomes who want to save as much for retirement as possible. For others, a solo 401(k) or some type of IRA is cheaper and easier to use.
How to Start a Solo 401(k)
If you decide a solo 401(k) is the best retirement plan for you, here’s how to set one up.
1. Get an EIN
First, you’ll need an Employer Identification Number (EIN). Self-employed people don’t usually need to have one of these because they can file their taxes using their Social Security Number. If you apply for an EIN online, you can receive it immediately. You can choose to fill out IRS Form SS-4 instead, but you’ll have to wait about four days to receive your EIN if you fax the form and about four weeks if you mail it.
2. Choose a Provider
Next, choose a provider for your plan. Most brokerage firms, including online brokerages, can set up this type of plan for you. Look for a financial institution with a good reputation, low fees, and the kinds of investments you want for your fund.
3. Open the Account
The broker will give you an account application and a plan adoption agreement. This lengthy document lays out details such as how contributions to the plan will be deposited and where the plan’s funds will be held. Your broker will walk you through the steps to fill it out. You’ll also have to create a set of employee disclosures explaining how the plan works. The IRS requires these even for a solo plan, so you’ll have them in case you ever hire employees.
4. Set up Contributions
You can set up regular automatic withdrawals to fund your account or make a lump-sum contribution at any time. If you want to fund your plan for this year, aim to set up your plan and make your contribution by December 31st. You can invest your contribution in any type of investment option your broker offers, such as index funds, mutual funds, ETFs, or individual stocks and bonds.
5. Maintain the Fund
Once your fund is set up, keep an eye on its balance. Once it gets up to $250,000, you’ll need to start filling out Form 5500-EZ each year. However, since you can only contribute a maximum of $58,000 per year, it’ll take a while to get to this point.
A solo 401(k) has many benefits for self-employed people. It allows you to save more of your pre-tax income each year than most other types of plans, and it’s much easier and cheaper to set up than a defined benefit plan. However, it’s still quite a bit more complicated to set up and maintain than an IRA, SEP, or SIMPLE IRA.
The best way to figure out whether the benefits of a solo-k outweigh the downsides for you is to crunch the numbers. Look at how much you make from self-employment each year, then calculate how much of your pre-tax income you’d be able to save under each type of retirement plan.
Consider not only the maximum contribution amount but also how much you can reasonably afford. If you’re only making $30,000 per year, then the $6,000 maximum donation for a traditional or Roth IRA is probably as much as you can manage. You might as well stick with these simpler plans rather than go to the extra trouble and expense of setting up a single-participant 401(k).
However, if you can afford to put aside a lot more for retirement each year, a solo 401(k) offers you the chance to make sure more of those savings are tax-sheltered. The money you save on taxes could be more than enough to offset the cost and effort of creating the fund.
For more information about retirement plans and other tools for small-business owners, check out our small-business archives.