Everything you need to know about Self Employed 401(k)

July 14, 2022
Solo 401k written on a card

Leaving your job to become your own boss can mean leaving behind some significant job perks, including a 401(k) or an employer-sponsored retirement plan. While you can no longer get free money from employer-matched contributions, you can still have a 401(k) as a freelancer.

A self employed 401(k), also known as a solo 401(k) or a one-participant 401(k), allows you to put more away than with your old employer-sponsored plan. As a freelancer, you can contribute to both 'you the employer' and 'you the employee.'

Here are some things every freelancer should know about the solo 401(k) – from how it works to how to set one up.

What Is a Self Employed 401(k)?

A solo 401(k) is a retirement account for self-employed business owners without employees that offers the same tax advantages as employer-sponsored 401(k)s. The IRS does not allow small business owners to contribute to a 401(k) if they have full-time employees. However, those without employees can cover both themselves and a spouse. Your spouse must receive an income from the business to qualify for contributions.

With a solo 401(k), you must follow the same IRS distribution rules as any other 401(k) to avoid steep penalties. Except for a few exceptions, you cannot take any distributions from a solo 401(k) before age 59 ½. Not only will you have to pay taxes on traditional 401(k) distributions taken before age 59 ½, but you will also have to pay penalties to the IRS.

With a solo 401(k), you can choose between a traditional or Roth 401(k). They differ in how taxes are handled. There are pros and cons to each type of 401(k), and a financial professional can help you determine which might be best for your financial situation. Here are the basic differences between the two.

Traditional Solo 401(k)

With a traditional 401(k), you contribute pre-tax dollars. You aren't taxed until you take qualified distributions from the account. One of the big advantages of a traditional 401(k) is that contributions reduce your annual tax bill.

Roth Solo 401(k)

A Roth 401(k) is essentially the opposite. You contribute after-tax dollars, but distributions are tax-free. A Roth is a good choice for those who expect higher retirement income and the need to reduce taxes in retirement.  

What’s the Contribution Limit of a Solo 401(k)? 

Like all 401(k)s, there is a limit to how much you can contribute each year, and solo 401(k) contribution rules can get confusing.

As previously mentioned, you can contribute to yourself both as an employee and an employer. Per IRS rules for the 2022 tax year, the maximum combined amount you can contribute to a self employed 401(k) is $61,000. If you are 50 or older, you can also make up to an additional $6,500 in catch-up contributions for a total of $66,500. Here is how much you can contribute as an employee and an employer:

  • Employee contribution: Up to $20,500 or 100% of compensation, whichever is less
  • Employer contribution: Up to 25% of compensation as defined by your plan

You might not qualify to contribute the maximum $61,000 (or $66,500 for those over 50). You must use an IRS calculation to determine your individual contribution limit based on your earned income. To ensure you do not exceed contribution limits, an accountant can help you figure out how much you contribute in any given year. An accountant can also advise you on steps to take if you do over-contribute.

Employee 401(k) limits apply to an individual and not a plan. If you still work a regular job while getting your freelance business going and are participating in a company-sponsored 401(k), your contribution limits apply across all 401(k) plans and not each individual plan that you may have.

When Can I Open a Solo 401(k)? 

If you want to open a solo 401(k) for this tax year, you must do so by December 31. You must make your employee contribution by the end of the calendar year, but you have until the deadline for filing taxes to make your employer contribution.

What Do I Need to Open a Solo 401(k) Account? 

The only thing you need to open a solo 401(k) is an EIN (Employer Identification Number) from the IRS. You can open a solo 401(k) at most online brokers. You will have to complete an account application and a plan adoption agreement. Then you can set up your contributions.

With a solo 401(k), you can invest in almost any asset class your broker offers. This may include individual stocks, bonds, exchange-traded funds, index funds and mutual funds.

Consider a Self Employed 401(k) to Save for Your Retirement

Don't leave behind saving for retirement when you leave regular employment for freelancing. While determining self employed 401(k) contributions is confusing, it is worth learning how to set up, contribute to and manage a solo 401(k). Enlist the help of an accountant if you don't want to worry about making contribution errors.

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