A solo 401(k)—also known as an individual 401(k), one-participant 401(k), or uni-401(k)—is a tax-advantaged retirement account specially designed for business owners without full-time employees. (However, if you’re married and your spouse works in the business, they can also contribute to the solo 401(k) as an employee.) Here's what you need to qualify.
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In 1978, Congress enacted Section 401(k) of the Internal Revenue Code (IRC), giving employees the opportunity to shelter a portion of their pre-tax wages by making contributions to a tax-advantaged retirement plan.
Initially overlooked, this obscure provision gained significance when retirement benefits consultant Ted Benna discovered its potential in 1980. Benna realized that this new paragraph of the tax code meant that employers could offer matching bonuses to incentivize employees to make tax-deferred retirement contributions.
Benna’s insights, however, were different from what Congress had intended. Section 401(k) never explicitly authorized a new type of retirement savings account—the provision was merely enacted to discourage companies from creating profit-sharing plans that disproportionately benefited executives.
Nonetheless, Benna’s supervisor was well-connected with officials in the Reagan administration, and managed to convince them of the merits of Benna’s idea. As a result, the IRS authorized the funding of 401(k) plans via employee salary deductions in 1981, marking the birth of the modern 401(k) savings plan.
Today, 401(k) plans are a near-ubiquitous workplace benefit provided by large employers, and have become one of the most popular ways to save for retirement in the United States. In aggregate, 401(k) plans hold $6.9 trillion in assets—about 27.6% of all retirement assets in the country.
A 401(k) Plan for the Self-Employed
Although 401(k) plans rapidly gained popularity among traditionally-employed Americans in the late 20th century, self-employed savers were less enthralled.
Sole proprietors and small business owners found 401(k) plans to be difficult to set up, cumbersome to administer, and expensive to maintain. And from the outset, there was little to gain from the hassle: a 401(k) plan’s annual contribution limits were on par with the more straightforward Simplified Employee Pension Individual Retirement Account (SEP-IRA).
However, things changed in 2001 when Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). Pronounced “Egg-tra”, the Act changed the way contributions (and contribution limits) were calculated, allowing self-employed savers to funnel a much greater amount of money into their solo 401(k)s than they previously could.
Thanks to EGTRRA, solo 401(k)s have become a highly popular retirement arrangement among self-employed Americans. Like its multi-participant counterpart, solo 401(k) plans offer compelling tax advantages, increased contribution limits, and flexible investment choices.
What is a Solo 401(k)?
A solo 401(k)—also known as an individual 401(k), one-participant 401(k), or uni-401(k)—is a tax-advantaged retirement account specially designed for business owners without full-time employees. (However, if you’re married and your spouse works in the business, they can also contribute to the solo 401(k) as an employee.)
Though solo 401(k) plans do not come with income limits or age requirements, you’ll still need the following to qualify:
Traditional and Roth Solo 401(k) Plans
As with an employer-sponsored 401(k), a solo 401(k) comes in two types: the traditional solo 401(k) and the Roth solo 401(k).
In a traditional solo 401(k), you make pre-tax contributions. In return, you receive an upfront tax deduction—equivalent to the amount you contributed—against your income in the current year. However, withdrawals during retirement are subject to income taxes.
In contrast, you make after-tax contributions to a Roth solo 401(k). While you won’t receive a tax break in the current year, you’ll enjoy tax-free growth and tax-free withdrawals in retirement.
Solo 401(k) Contribution Limits
The IRS adjusts contribution limits to solo 401(k) plans annually to account for inflation. In 2023, the total annual contribution limit for a solo 401(k) is $66,000, up $5,000 from $61,000 in 2022. If you’re 50 years of age or older, you can make an additional catch-up contribution of $7,500, putting your overall contribution limit at $73,500 for 2023.
One perk of the solo 401(k) plan is the flexibility to contribute both as an employee and as an employer. As an employee, you can make pre-tax or after-tax contributions up to 100% of your compensation or earned income or $22,500 in 2023 (or $30,000 if you’re 50 or older), whichever is less.
As the employer, you can elect to make additional profit-sharing contributions of up to $43,500, which can only be made on a pre-tax basis. Profit-sharing contributions are additionally limited by your compensation as an employee, the specifics of which depend on your business entity type.
For S corporations, C corporations, multiple member LLCs, and partnerships, employer profit-sharing contributions can be up to 25% of your W-2 compensation (or $43,500, whichever is less).
For pass-through entities like sole proprietorships and single-member LLCs, the maximum allowable contribution is the lesser of $43,500 or 20% of your net self-employment income. This is calculated by subtracting half of your self-employment tax and any plan contributions you made for yourself from your net profit. Notably, the compensation limit used to determine your contribution is set at $330,000 in 2023. To ensure compliance, make these contributions prior to the tax filing deadline or any applicable extension.
Similarly, If your spouse earns income from the business, they can also contribute to the solo 401(k) as an employee, subject to the same contribution limits as the business owner. As the employer, you can also make a profit-sharing contribution for your spouse, up to 25% of their compensation. In other words, a qualifying couple can save up to $132,000 annually in their solo 401(k), or $147,000 if they are 50 or older in 2023.
As an example, let’s consider a married couple in their forties who run an S corporation. Between the two of them, they earned W-2 wages of $150,000 in 2023. As employees, they can each contribute up to the maximum limit of $22,500, resulting in total elective deferrals of $45,000.
Further, as their own employers, they can make an additional profit-sharing contribution of 25% of $150,000, or $37,500 each. In a single year, the couple would be able to save $22,500 + $22,500 + $37,500 + $37,500 = $120,000 towards their retirement through their solo 401(k) plan.
Solo 401(k) Tax Advantages
Besides for its high contribution limits, a solo 401(k) provides self-employed savers with significant tax advantages. One notable advantage is that all profit-sharing and matching contributions you make as an employer to your own solo 401(k) are tax-deductible, as are the costs and ongoing maintenance fees of the plan. This reduces your business’ income tax liability in the current year.
Another significant advantage of a solo 401(k) is that it is exempt from Unrelated Business Income Tax (UBIT) on leveraged real estate investments made through the plan. While IRAs may be subject to UBIT when investing in leveraged real estate, a solo 401(k) enables you to finance real estate transactions using (non-recourse) debt without needing to owe UBIT in the current year.
Solo 401(k) Loan Options
Unlike a traditional or Roth IRA, you can take out a loan from your solo 401(k) plan for any purpose without taxes or penalties as long as your plan provider allows it. Under Internal Revenue Code Section 72(p), you’re eligible to borrow 50% of your account’s value or $50,000, whichever is less.
Solo 401(k) loans have a maximum loan term of 5 years unless the loan is intended for the purchase of a primary residence, in which case the loan term can be extended up to 15 years. The interest rate is usually set at prime rate + 2%, and you must make substantially equal payments at least quarterly.
As the trustee and administrator of your solo 401(k) plan, all you need are the necessary loan documents to start the loan process. And because you’re essentially borrowing from yourself, no third-party approval, underwriting fees, or loan origination costs are associated with a solo 401(k) loan. To access the loan amount, you can simply write a check to yourself from the trust account of your Solo 401(k) plan.
That said, it’s advisable that you stay within the borrowing limits, as exceeding the maximum allowed amount will be treated as an early distribution. This means that the excess amount will be subject to a 10% tax penalty, in addition to regular income taxes based on your tax bracket.
For example, if your account balance is $20,000, the maximum loan amount would be $10,000, or 50% of your account value. If you decide to borrow $15,000 instead, the extra $5,000 would be subject to a 10% penalty of $500, on top of regular income taxes.
Solo 401(k) Withdrawal Rules
Similar to other retirement accounts, a solo 401(k) allows you to take qualified distributions once you’re 59 ½ years old. Any distributions you take from your traditional solo 401(k) before the age of 59 ½, whether contributions or earnings, will be considered an early withdrawal. As a reminder, these withdrawals are subject to a 10% penalty tax in addition to income taxes on the withdrawn amount.
With a Roth solo 401(k), you can withdraw your contributions early without incurring the 10% penalty tax or income taxes, but your account must be at least 5 years old. However, if you withdraw earnings from a Roth solo 401(k) before reaching 59 ½, both the 10% penalty tax and income taxes will apply.
Under certain circumstances, the IRS may waive the 10% penalty for early withdrawals associated with both traditional and Roth solo 401(k) accounts. These exceptions may include cases involving permanent disability, high medical expenses, military service, or a Qualified Domestic Retirement Order (QDRO) issued during a divorce.
Finally, both traditional and Roth solo 401(k)s come with required minimum distributions (RMDs), which exist to prevent taxpayers from taking advantage of the account’s tax-advantaged benefits indefinitely.
A solo 401(k) plan participant must take their first RMD by April 1st of the year following the year they turn 72. Subsequent RMDs must be completed by December 31st of each year. Failure to take required minimum distributions results in an excise tax equivalent to 25% of the required amount that was not withdrawn. Luckily, the SECURE Act 2.0, which was passed by Congress in 2022, drops the penalty to 10% if the RMD error is remedied within two years of its due date.
At TSG Alpha Partners, our expert financial advisors are proud to partner with diligent savers like yourself. With deep familiarity across tax strategy, retirement planning, risk management, and estate planning, our seasoned experts can help recommend suitable retirement account options, explore alternative investment opportunities, and align your financial goals with the right investment vehicles.
Get in touch with us today to see how we can help you exceed your retirement objectives.
