Solo 401(k) for Small Business Owners: 11 Solo 401(k) Advantages You Need to Know

By James On Jul 19, 2023

A solo 401(k), also called a one-participant 401(k) or Individual 401(k), is designed for self-employed workers or business owners with no employees. An Individual 401(k) allows business owners to make contributions both as an employee and as an employer, thus maximizing their retirement contributions and business deductions.

Although the IRS doesn’t allow you to contribute to a solo 401(k) if you have full-time employees, you can use the plan to cover you and your spouse. Since this plan covers the business owner(s) and their spouse(s), it is not subjected to the complex ERISA (Employee Retirement Income Security Act of 1974) rules that set minimum standards for employer retirement plans with non-owner employees.

Eligibility Requirements

In order to invest in a solo 401(k), you must meet these requirements:

You must be a sole proprietor, small business owner without employees, independent contractor, or freelancer.
You must have earned income (can be verified through tax records).

Solo 401(k) Advantages for Small Business Owners

Solo 401(k) is designed exclusively for small, owner-only businesses. This plan is tax-efficient, cost-effective, and offers all the benefits of a self-directed IRA plan and additional benefits. Some of the advantages of Solo 401(k) that makes it so appealing to self-employed business owners are:

1. Higher Contribution Limits

As an employee, for both 2023, the maximum contribution you can make towards your solo 401(k) is $22,500. If you are 50 or older, you can make an additional catch-up contribution of $7,500.

As an employer, you can contribute up to 25% of your compensation. For 2022, the total contribution limit for a solo 401(k) is $61,000 + $6,500 catch-up amount if you are 50 years and above. For 2023, the employer maximum is $66,000 + $7,500 catch-up amount if you are 50 years and above.

In other words, in 2023, the maximum solo 401(k) contribution limit is: $66,000 (as an employee $22,500 + as an employer $43,500) + $7,500 catch-up amount if you are 50 years and above, making the total contribution of $73,500 for the year.

2. Unlimited Investment Opportunities

With a solo 401(k) plan, you have the freedom to invest in almost any type of investment options that are of your interest. The investment options include real estate (foreclosures, rentals, tax liens, raw land, etc.), precious metals, private businesses, hard money, stocks, mutual funds, and peer-to-peer lending. Moreover, the income and gains earned from these investments will go back into the solo 401(k) plan tax-free.

Additionally, you can establish a checking account for your solo 401(k) investments with a bank or brokerage account of your choice at no additional charge. As trustee of the solo 401(k) plan, you will have total control over your retirement assets to make tax-free real estate and other investments without any custodian consent.

3. Checkbook Control

As a trustee of the solo 401(k) plan, you can open a solo 401(k) account in any local bank or credit union with checkbook control over the plan. This means you don’t need to hire a trustee to manage your account. You have the sole authority over the 401(k) to take any action you choose and make any decisions you feel are best for you. Moreover, there are no custodial fees for maintaining the account.

4. Flexible Contribution Options

Contributions to a solo 401(k) plan are completely at your discretion. This means that you have an option to contribute as much as it’s legally possible with the flexibility of suspending or reducing the contributions if and when necessary.

5. Roth Type Contributions

Generally, high-income earners who own IRAs are not allowed to contribute to a Roth IRA or convert their IRA to a Roth IRA. On the other hand, a solo 401(k) has an in-built Roth sub-account, which you can contribute to without any income restrictions. A Roth Solo 401(k) sub-account allows you to make Roth type contributions, giving you the ability to make larger contributions than with an IRA.

6. No Custodian Fees

Since you serve in the role of a trustee for your solo 401(k) plan, you are not required to hire a bank or trust company. Thus, you can establish a solo 401(k) plan without paying any custodian fees or transaction fees. This also means that all assets of the 401(k) trust are under your authority, offering you the flexibility to avoid delays and expenses associated with an IRA custodian, and enabling you to make quick investment decisions when a right opportunity presents itself.

7. Cost-Effective Administration

Generally, the solo 401(k) plan lacks non-owner employees, its administration is very simple. Unless your solo 401(k) plan exceeds $250,000 in assets, there is no annual filing requirement. If it does exceed $250,000 in assets, you will have to fill out form 5500-EZ to file a short information return with the IRS.

8. UDFI Tax Exemption

When your IRA invests in buying real estate that has been financed, it creates Unrelated Debt-Financed Income (UDFI) on which taxes are applied. The tax paid for UDFI is referred to as Unrelated Business Income Tax or UBIT. Solo 401(k) plans are exempted from UDFI rules and UBTI tax. This exemption is a significant tax benefit of using a Solo 401(k) plan instead of an IRA for purchasing real estate.

9. Offset the Plan Cost with a Tax Deduction

Since you pay your solo 401(k) with your business funds, you are eligible to claim a deduction for the cost of the plan, including annual maintenance fees. The cost deduction associated with having and maintaining the solo 401(k) plan helps reduce your business’s income tax liability, thus offsetting the cost of adopting a self-directed solo 401(k) plan.

10. Borrowing Option at a Low-Interest Rate

The solo 401(k) allows participants to borrow up to 50% or $50,000 (whichever is less) of their total account value for any purpose at a low-interest rate.

For example, if a participant has an account balance of $50,000, the maximum amount that they can borrow from their solo 401(k) account is $25,000.

11. Consolidate Retirement Saving Account with Rollovers

Your solo 401(k) plan can accept fund rollovers from retirement savings plans, such as IRAs, SEP, or old employer-sponsored 401(k) plan. You can directly roll over the funds from qualified retirement plans to your new 401(k) plan for investment or loan purposes. However, you cannot roll over funds from a Roth IRA into a solo 401(k) plan.

Solo 401(k): Quick Facts

Breakdown of the need-to-know basics of solo 401(k):

Eligibility rules

Must be a business owner with no employees. No age or income restrictions.

Contribution limit

$66,000 in 2023. Additional catch-up contribution of $7,500 if you are 50 or older.

Tax on contributions

Traditional 401(k): Taxable income for the year is reduced as contributions are made with pre-tax dollars.

Roth 401(k): Contributions are made with after-tax dollars.

Tax on qualified distributions in retirement

Traditional 401(k): Qualified distributions in retirement are taxed as income.

Roth 401(k): Qualified distributions in retirement are tax-free.

How to open a solo 401(k) plan

Use your employer identification number to open a solo 401(k) at many online brokers.

Final Words

If you are self-employed or running a small business, a solo 401(k) plan is the best plan that can help you set up a comfortable and secured retirement. If you are considering opening a solo 401(k), do your due diligence and speak with your financial advisor, and make a choice that best fits you.