Self-Directed Solo 401(k) Guide
Learn more about Solo 401(k) plans, starting with the basics.
Solo 401(k) Basics
In 2001, the U.S Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). EGTRRA reduced taxes and amended the tax law to allow self-employed individuals to have a special 401(k) retirement plan similar to a Simple 401(k).
This new plan was an improvement over a self-employed person using a Simplified Employee Pension Plan - Individual Retirement Account (SEP-IRA) or a self-directed IRA.
Solo 401(k) Plan
The special 401(k) plan for the self-employed mimics the traditional 401(k) plans already enjoyed by many companies’ employees who receive W-2 income. Employees contribute a portion of their pre-tax earnings to their 401(k) plan, and the employer matches this amount.
A qualified self-employed small business owner may contribute both the employer’s (as profit sharing) and the employee’s share to this type of 401(k) plan for themselves and their spouse.
This special 401(k) retirement plan for self-employed individuals and their spouses became commonly known as a Solo 401(k) or Solo 401(k). This account type may also be known as a Self-Employed, Personal, Self-Directed, Individual, or a one-participant 401(k).
History of Regular 401(k) Plans
The 401(k) in the name comes from section 401(k) of the IRS Tax Code. The Internal Revenue Code changed in 1978 through ERISA legislation and made these accounts possible. However, the first 401(k) plan did not exist until 1981.
The 401(k) concept was invented in 1981 by an accountant as an interpretation of the ERISA laws. There are many types of 401(k) plans, such as a defined contribution plan for employers with many full-time employees and the Solo 401(k) for a self-employed person with no full-time employees except a spouse.
401(k) Plan Responsibilities
For the self-employed looking to get the most out of their retirement accounts, savings, tax deduction management, and investment efforts, the Solo 401(k) is the best retirement plan option currently available compared to a traditional 401(k).
As a self-directed 401(k) plan manager, if you are a clever investor, you can build up plan assets, so there is plenty of fixed income funding when you retire. You must take the required minimum distributions starting from the age of 72.
If you qualify for the Solo 401(k) you can contribute up to $66,000 annually in 2023 ($7,500 more as a catch-up contribution for those who are 50 or older). As allowed by the IRS, you may invest in many assets as long as the investment is not a prohibited transaction. You also enjoy the benefits from having a tax-deferred retirement fund account while not paying exorbitant fees.
Who qualifies for a Solo 401(k)?
The rules to qualify for a Solo 401(k) are straightforward and more flexible than a Simple IRA account. A person must have self-employment income from their business efforts. Self-employment may be full-time or part-time. A Solo 401(k) plan participant may earn W-2 wages from self-employment, profit sharing, or IRS form 1099 income as an independent contractor.
What type of business entity can set up a Solo 401(k)?
The business may be a sole proprietor, a partnership, a Limited Liability Company LLC, or a closely-held corporation (C or S). The entity of a sole proprietorship or any other type will suffice. All that matters is that all the business owners, who are participants in the Solo 401k plan, pay self-employment tax.
Example: Barbara works for an advertising agency and receives a salary as W-2 wages. She also has a freelance business and earns self-employed income. She may qualify for a 401(k) plan at the advertising agency and a Solo 401(k) for her freelance business. If her husband helps her with the freelance business, he may participate in the Solo 401(k) plan too.
What are the technical requirements for a Solo 401(k) plan?
The business entity may not have any full-time employees besides the business owners and their spouses. The business may have as many part-time employees as desired without a limit. This rule comes from the IRS “discrimination testing” policy. Any full-time employee must receive the same retirement benefits as other full-time employees.
The IRS considers an employee full-time if the person earns wages for more than 1,000 work hours in a tax year.
Exceptions to this rule are for persons under 21, non-resident aliens, and some union workers who have retirement benefits from collective bargaining efforts.
What are the advantages of a Solo 401(k)?
The advantages of a Solo individual 401(k) that make this retirement plan account very attractive when managing taxable income include the following.
Salary Deferral Contribution
A traditional 401(k) usually has plan limits and caps on an employee’s contribution because the employer makes a matching contribution. With a Solo 401(k), a plan participant may contribute 100% of their earned income to the maximum allowed amount, which is $22,500 in 2023 ($30,000 for those 50 years or older).
The employee deferral contributions are per person, not per Solo 401(k) plan. Suppose an individual participates in more than one Solo 401(k) plan, such as having self-employment income from more than one source. In that case, the maximum amount allowed for salary deferral is the same, $22,500 in 2023, and for all the plans added together.
In addition to the salary deferral, the business can contribute up to 25% of a plan participant’s income, which is the net self-employment earnings, after deducting 50% of the self-employment tax and any contributions for that participant.
The salary deferral and business contribution are subject to a maximum contribution per individual’s Solo 401(k) account of $66,000 in 2023 (not including any catch-up contributions for those 50 or older).
No Special Custodian Needed
Unlike an IRA, a Solo 401(k) plan does not need a special custodian paid to manage the plan. A Solo 401(k) plan is a trustee-directed plan with the owner serving as the trustee.
A Solo 401(k) plan account is easy to open at Rocket Dollar for a one-time setup fee and then maintained for a modest monthly fee for faster and more economical transactions.
These savings are significant compared to the standard plan administrator fees in the many thousands of dollars. Each investment transaction takes a long time to process and costs more fees. A self-directed Solo 401(k) gives the owner direct and immediate check-writing control of the funds.
Personal Loans from the Solo 401(k) Account
The Solo 401(k) rules allow for a personal loan for the lower amount of 50% of the account value or up to $50,000. Getting this loan is like having a credit card for a low-cost cash advance and does not depend on your credit score. This benefit gives a tax-free use of these funds for any purpose.
Leveraged Real Estate Tax Benefit
A Solo 401(k) does not pay tax on Unrelated Debt-Financed Income (UDFI) from leveraged real estate, as long as the real estate loan meets the requirements under section 514 of the IRS Code.
Fixing Prohibited Transactions
If a mistake happens, a prohibited transaction with a Solo 401(k) account is fixable, unlike an error with a SEP IRA account that may force the account’s liquidation and cause a tax liability.
Optional After-Tax Contributions
If the Solo 401(k) plan also allows after-tax contributions, they are through the same plan, and the funds are in a sub-account designated as having Roth funds. This option is not possible with a SEP IRA.
One benefit of Roth IRA contributions and Roth Solo 401(k) contributions is that the tax is already paid. Additionally, there is no capital gains tax on any gains. When taking qualified distributions during retirement, there are no taxes to pay when withdrawing Roth funds.
What are the Solo 401(k) contribution types?
The pre-tax/tax-deferred contribution types for a Solo 401(k) plan for each plan participant and the same amounts for their spouses include the salary deferral and the business contribution up to the total maximum annual Solo 401(k) contributions of $66,000 in 2023 (not including any catch-up contributions for those 50 or older). This limit is the same as a SEP IRA.
Contributing the same maximum amount for yourself and your spouse may potentially double the maximum limit for a married couple to $132,000.
For the salary deferral contribution, a plan participant may contribute 100% of earned income up to the maximum amount allowed, which is $22,500 in 2023.
The business contribution is up to 25% of your income, which is your net self-employment earnings after deducting 50% of your employment tax and contributions for yourself.
Catch-up contributions of an extra $7,500 per year in 2023 are possible for those aged 50 or older.
If allowed by a customized Solo 401(k) plan, optional contributions include after-tax contributions held in a Roth 401(k) subaccount.
When are contributions fully vested?
For a standard 401(k) plan, the vesting schedule may take three to five years for the employee to benefit from the employer’s retirement plan contributions for highly compensated employees. With a Solo 401(k) plan, the employer and employee are one and the same. This vesting schedule structure means that 100% of the plan contributions have immediate vesting up to the contribution limit.
What investments can you make with a Solo 401(k)?
Almost any type of investment is allowed unless it involves a prohibited transaction with a disqualified person. The Solo 401(k) plan account offers more choice than a regular employee 401(k) plan, which may only have mutual funds and EFTs as investment options. Mutual funds may have hefty management fees that might reduce performance over the long term by lowering investment income.
What investment choices are available?
Allowed investments include annuities, stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), unit investment trusts (UITs), and real estate, which is not for personal use or by a close relative.
Can a Solo 401(k) buy real estate?
The investment opportunities in real estate include foreclosures, short sales, rental homes, vacation rental properties, raw land, commercial real estate, first trust deeds, commercial paper, mortgage notes, hard money lending, tax liens, and more.
When using mortgage financing for leveraged investments in real estate, a Solo 401(k) does not have to pay tax on Unrelated Debt-Financed Income (UDFI) if the real estate loan meets the requirements noted in the IRS publication about IRS Code section 514.
Besides real estate, investment in an alternative asset is also possible such as cryptocurrencies, precious metals, commodities, futures, options, oil and gas leases, venture deals, hedge funds, private equity, and private debt.
What types of investments are prohibited with retirement accounts?
A prohibited investment option for a retirement plan account includes the following:
Any derivative trade with unlimited risk is prohibited, such as naked call writing or ratio spreads. Covered call writing is allowed.
Annuities purchased from an insurance company are allowed. However, insurance taken out on a plan’s participant is not allowed except for a modest amount of insurance with a very low death benefit. The reason is that the plan’s purpose is to save retirement contributions and not to function after a participant’s death.
Whole life insurance is allowable as long as the premiums do not exceed 50% of the business contribution to the participant’s account. This amount reduces to 25% of the business contribution to the participant’s account for the term and universal life policies.
Collectibles are potentially good investments, but they are not allowable under the Solo 401(k) rules with Solo 401(k) account funds.
Coins that have collectible value are not allowed investments. However, some coins held just for the weight of the precious metal they contain are permitted, such as the American Eagle, American Gold Buffalo, American Silver, Austrian Gold Philharmonics, and Canadian Maple Leaf coins.
Can a spouse contribute to Solo 401(k)?
Yes, if the spouse works for the business and earns self-employment income, the contribution rules are the same. With the spouse also working for the same company and participating in the Solo 401k plan, this essentially doubles the maximum limits of each contribution type.
The pre-tax/tax-deferred contribution types for a Solo 401(k) plan for each spouse of a business owner is the same amount, including the salary deferral and the business contribution up to the total maximum annual limit of $61,000 in 2022 (not including any catch-up contributions for those 50 or older).
Contributing the same maximum amount for a spouse doubles the maximum contribution limit for a couple who work together in a business to $102,000 in 2022.
Who is eligible?
To be eligible for the Self-Directed Solo 401(k) account, you must be self-employed and have no full-time employees, except for your spouse. Further eligibility requirements and exceptions are here. When setting up your account plan, you may want to work with your CPA or another financial advisor.
What is the annual contribution limit?
Up to $61,000 annually in 2022 of tax-advantaged retirement dollars per participant are allowed to deposit in a Solo 401(k) account if you choose to maximize your personal and company contributions. Learn how Rocket Dollar can help you capitalize on these contributions.
Can I borrow from my Solo 401(k)?
The Self-Directed Solo 401(k) allows for loans. The loan option will enable you to borrow from your retirement funds up to 50% of the plan value or $50,000, whichever is less. Solo 401(k) holders may use loans to pay off personal debt, fund a business, or use as the holder sees fit. If you want to take a loan from your 401(k), fill out the loan application provided on your online Dashboard.
What if I need funds in an emergency?
If the funds you need exceed the allowed amount of a loan, then there is a 10% penalty for the amounts withdrawn before you reach age 59½, plus you must pay income tax on the amount of the withdrawal as ordinary income.
Exceptions to this 10% penalty rule are:
- If you become permanently disabled.
- The withdrawn funds pay for qualified higher education expenses.
- To pay the amount of unreimbursed medical expenses greater than 10% of your adjusted gross income (for those under 65).
- Specific distributions for reserve military members called up to serve in active duty.
If you qualify for an exception to the 10% penalty, you still have to pay the ordinary income tax on the amount withdrawn unless the funds are held as Roth contributions as after-tax funds by the rules under your Solo 401(k) plan.
How fast can I open an account?
Rocket Dollar can open a self-directed Solo 401(k) in two to four weeks for a silver account or two weeks for priority processing with the Rocket Dollar Gold Plan.