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Solo 401(k) Rules for the Self-Employed

solo 401(k) rules

There are important Solo 401(k) rules to follow in order to remain IRS compliant. Failure to follow the rules can result in steep penalties and potentially the disqualification of your retirement plan. However, if you make sure to follow the rules, you can experience all the benefits the Solo 401(k) plan has to offer, which we will detail in this article.

 
Key Points 
  • The Solo 401(k) plan is the best retirement option for the self-employed
  • IRS rules can be difficult to navigate for many
  • It’s important to work with a plan provider who can help with the Solo 401(k) rules

What is the Solo 401(k) Plan?

One of the main advantages of being an entrepreneur or small business owner is that you have control over your own life and you’re your own boss. You should take the same approach for your retirement savings.

A Solo 401(k) plan is not a new type of plan. It is essentially a traditional 401(k) plan that covers only one employee. As a result, it’s not subject to the complex rules and regulations of ERISA.

This type of plan is growing in popularity, which is largely a result of the Economic Growth Tax Relief Reconciliation Act. The EGTRRA became effective in 2002. One of the provisions in the act changed how salary deferral contributions are treated when calculating the maximum deduction limits for contributions to a 401(k) plan.

The Solo 401(k) Plan is a design by the IRS specifically for the self-employed or small business owner with no employees. Depending on the plan documents you establish, a Solo 401(k) (also known as the self-directed individual 401(k) plan) allows you to make the same alternative asset investments as a Self- Directed IRA. However, you don’t need to hire a custodian or create an LLC (limited liability company).

Important Facts About the Solo 401(k)

The Solo 401(k) plan documents dictate the type of options you will have in your plan. For example, you can establish a plan with a bank or financial institution but will only be able to invest in traditional investments. Traditional investments include stocks and bonds. Additionally, you will have no loan feature or ability to make Roth or after-tax contributions.

But if you establish a Self-Directed Solo 401(k) plan with IRA Financial, you can take advantage of all available options. This includes features such as Roth and after-tax contributions, the $50,000 loan feature, and the ability to make traditional as well as alternative asset investments, such as real estate. You can do all of this tax free!

Best of all, you can serve as trustee of the plan and gain “checkbook control” over your funds.

Related: Tips for Making Solo Investments

Make Higher Contributions

Before we get into the Solo 401(k) rules, let’s first take a look at some of the benefits of establish a plan. One of the main benefits is the opportunity to make higher annual contributions in pretax, after-tax or Roth.

A Solo 401(k) plan includes both an employee and employer profit sharing contribution option. On the other hand, a traditional IRA has a very low annual contribution limit, and a SEP IRA has only an employer profit sharing contribution option.

Under the 2023 Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum annual employee deferral contribution in the amount of $22,500, which is $2,000 more than this year.

If you’re at least age 50, you can make a maximum annual employee deferral contribution in the amount of $30,000, and increase of $3,000. Plan participants can make this amount in pretax, after-tax or Roth. Simply choose the contribution that best fits your current and/or future financial needs.

On the profit-sharing side, the business can make a 25% annual contribution (or 20% if you have a sole proprietorship or single member LLC) up to a combined maximum. The maximum amount you may contribute to a Solo 401(k) is $66,000 or $73,500 if at least age 50.

Solo 401(k) Tax Advantages

Many features of the Solo 401(k) plan make it so appealing and popular among self-employed business owners. Remember, the ability to take advantages of all available plan options is dependent on the plan documents.

The following chart will illustrate the advantages for a self-employed attorney of using a Solo 401(k) Plan:

 Traditional IRASEP IRASolo 401k
Maximum Annual Contributions$6,500 + $1,000 if age 50+20% (if sole proprietorship or single member LLC) or 25% if W-2 employee, up to $66,000$66,000 + $7,500 if age 50+
IRA Custodian RequiredYesYesNo – account can be opened at any local bank
Checkbook ControlYes – but only with a Self-Directed IRA LLC which requires the formation of an LLCYes – but only with a Self-Directed IRA LLC which requires the formation of an LLCYes – trustee with have checkbook control with no need for the formation of an LLC
Loan FeatureNoNoYes – ability to borrow the lesser of $50,000 or 50% of account value
Non-Recourse Financing for Real EstateYes – but the nonrecourse financing could be subject to the UBTI taxYes – but the nonrecourse financing could be subject to the UBTI taxYes -generally no tax on nonrecourse financing associated with a real estate acquisition
Roth FeatureNo – must establish a separate Roth IRANo Roth optionsYes – built in Roth component including a “Mega Backdoor Roth” option
    

Some additional advantages to a Solo 401(k) Plan:

  • Created by the IRS specifically for the self-employed or small business owner with no full-time employees.
  • Helps build your retirement nest egg by contributing up to $66,000 per year ($73,500 if at least age 50) –10 times the maximum contribution amount of an IRA.
  • Contribute to your plan using pretax or Roth (after-tax) funds.
  • Borrow up to $50,000 tax- and penalty-free and use those funds for any purpose, whether personal or business.
  • Take advantage of the “Mega Backdoor Roth” option allowing one to max out Roth contributions.
  • Invest in what you know and understand without tax, such as real estate, precious metals, tax liens, and much more.
  • As trustee of the plan, you can make investments easily.
  • Generate tax-deferred or tax-free income or gains on your plan investments, such as real estate.
  • Open your plan at any local bank – no need for a special IRA custodian.
  • Asset & creditor protection.
  • Purchase real estate with leverage without triggering tax.
  • Receive an IRS opinion letter confirming the legality of the plan.

Cover Your Spouse in the Solo 401(k) Plan

In order to be eligible for a Solo 401(k) plan, you must be self-employed or be a small business owner with no full-time employees other than yourself or a spouse.

According to the ERISA rules, a spouse is not an employee. Therefore, you can employ your spouse in the business and still be eligible for the plan without triggering the ERISA rules. Of course, the spouse must earn income from the business in order to make contributions to the plan.

Solo 401(k) Rules – Prohibited Transactions

Now let’s take a look at the Solo 401(k) rules, which are few.

A Solo 401(k) plan offers retirement account holders the ability to use his or her retirement funds to make almost any type of investment. The IRS only describes the type of investments that are prohibited.

In general, you cannot purchase collectibles or invest in any transaction that involves yourself or any disqualified person directly or indirectly. These rules are pursuant to IRC 4975.

Although the rules seem elementary, they can get complicated. This is why it is important to work with a self-directed retirement custodian to avoid triggering any of the prohibited transactions, as it can result in high penalties and sometimes the disqualification of the Solo 401(k) plan. Although passive custodians are non-fiduciary, IRA Financial can help you navigate the IRS prohibited transaction rules,

How You Can Establish a Solo 401(k) Plan?

Establishing a Solo 401(k) plan with IRA Financial is quick and easy.

  • Simply open an account on our industry-leading app.
  • You will be able to customize your plan based on your business and retirement needs.
  • Our team of specialists are standing by to help with any questions you may have throughout the set-up process.
  • Your plan can be established within 24 hours.
  • The new Solo 401(k) plan account can be opened at any local bank or financial institution. In addition, we can even open a bank account for you at Capital One bank in minutes at no charge.
  • Once your plan has been funded, gain checkbook control as trustee of the plan.
  • Fund the plan with a rollover of any pretax retirement funds, or by making a tax-deductible or after-tax (Roth) contribution directly to the new plan account.
  • All income and gains generated by your investment(s) will generally flow back to your Solo 401(k) without tax.
  • No annual IRS reporting or filing requirements if your plan assets are below $250,000.
  • No plan termination fee.

Get in Touch

If you have questions about the Solo 401(k) rules or general questions about the plan itself, contact IRA Financial directly at 800-472-0646. Join then tens of thousands of small business owners who have worked with IRA Financial to establish their self-directed retirement plan.

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