Last Updated on January 15, 2020
What is a Solo 401k?
A Solo 401k is a retirement plan specifically created for self-employed individuals without any full time employees other than a spouse. It lets a business owner save for retirement and invest in their future without being part of a larger corporation. For small business owners, LLC holders, contractors and consultants, this can be a huge win when it comes to retirement savings.
While there does not have to be a profit for the business each year, there must be a clear profit motive, demonstrated by the business owners’ intent to increase business income. The amount of available monies able to be invested is across 401k accounts, per person, and not per plan.
Investing with a Solo 401k
Investments from a Solo 401k can be used for traditional Wall Street purchases, as well as real estate and other alternative investments. If you wish to make both alternative and traditional investments, it’s important to establish your Solo 401k plan at a trust company, such as IRA Financial Trust, and not a bank or financial institution.
Unlike a larger corporation’s 401k plan, with a Solo 401k plan investments can be made in those companies which match with an investor’s corporate or social responsibilities. Solo 401k plans can be initiated by those who do have a corporate job and 401k but act as a consultant or contractor on the side.
Qualifications to Establish a Solo 401k
Qualifying for a Solo 401k plan isn’t exactly complicated, but there are specific requirements that must be met. The plan owner must show proof of a self-employed business activity, be it as an independent contractor, consultant, business, sole proprietorship, LLC or corporation. Typically a business will qualify as long as there are no other employees besides the owner and a spouse. Any form of business is potentially acceptable, as well, as long as income is received that can be reported on Schedule C.
Benefits of Using a Solo 401k
Solo 401k plans offer benefits that can only be reaped by their plan owners. They have high contribution limits because monies can be put in as both the employer and the employee. Solo 401k plans can be used to invest in real estate. And Solo 401k plans can be set up to establish checkbook control. Without employees other than a spouse, the Solo 401k is an amazing opportunity for business owners.
The Solo 401k should be set up at a trust rather than a bank, as this will enable the most control over the business owner’s money by the business owner. It can be difficult for banks to relinquish control, and as a business owner, money that belongs to the business should be directed by the business itself.
Common Solo 401k Misconceptions
Disqualifying investments for a Solo 401k plan can include passive rental income. If an LLC has been set up and only collects and distributes rental income to the owner, this will not be considered wages. This means that there is no acceptable process to set up an LLC for a rental business that will only collect and distribute rents – as this is considered a passive income, it does not register as wages and cannot be contributed to a retirement account.
Solo 401ks, then, are for business owners as well as contractors or consultants. Solo 401ks are able to be used to invest in real estate, but again, there is a Solo 401k misconception that individuals, such as real estate investors, can setup an LLC to collect rental income. Because this is considered passive income, you cannot contribute rental income to the Solo 401k.
401k Contribution Limits Increased
For 2020, Solo 401k contribution limits are higher than previous years. For business owners younger than age 50, that maximum amount a self-employed individual can contribute for 2020 is $57,000. For those age 50 and older, an extra $6,500 per year is allowed in “catch-up” contributions, totaling $63,500 for the year. Contributions are made on a pre-tax basis, unless investing in a Roth 401k, which would be contributed on an after-tax basis.
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Did you know?
The Solo 401k is not a new type of retirement plan. It is essentially a traditional 401(k), but designed for one employee, therefore it isn’t subject to the overly complex ERISA rules. The plan gained popularity in 2002 when the Economic Growth and Tax Reconciliation Act of 2001 (EGTRRA) went into effect. EGTRRA added key provisions to the Solo 401(k) that made it more appealing than the SEP IRA and SIMPLE IRA. Today, it is the most popular and robust retirement plan for the self-employed and owner-only businesses.