What Is a Solo 401(k)?

When you work for a company, one of the benefits your company is likely to offer is a 401(k), which is a helpful tool in saving for retirement. 401(k)s offer a convenient way to save, and they come with some nice tax perks.

If you’re self-employed, you won’t have a traditional 401(k) offered to you by an employer. As your own employer, you’re eligible to open a solo 401(k), which is a traditional 401(k) for business owners without employees. Here’s the rundown on how it works and who’s eligible so you can decide if it’s a good option.

How does a solo 401(k) plan work?

As far as self-employed retirement plans go, solo 401(k)s certainly stand out. That’s because you can make contributions as both the employee and the employer. Here is how a solo 401(k) is similar to a traditional 401(k):

Contributions are tax-deductible

You can deduct employee contributions on your federal tax return, which reduces your taxable income for the year.

Your money can grow tax-deferred

Your money has the potential to grow tax-deferred until you make withdrawals.

There are required minimum distributions (RMDs)

You must begin taking mandatory annual withdrawals beginning at age 73.

You’ll be penalized for taking early distributions

Tapping your funds before age 59½ will likely result in a 10 percent early withdrawal penalty.

You can structure a solo 401(k) as a Roth account

Roth accounts are funded with after-tax dollars, so you won’t be taxed on withdrawals. RMDs don’t apply.

Solo 401(k) contribution limits

Here are the contribution limits for 2024:

• As the employee: You can put in up to $23,000. Self-employed people who are 50 and older can contribute an extra $7,500.
• As the employer: You can contribute up to 25 percent of your compensation. According to the IRS, if you have an unincorporated business, you can calculate this by adding up half of your self-employment tax and contributions for yourself and subtracting that total from your net earnings from self-employment. (But keep in mind, there is a $345,000 cap on how much compensation can be contributed in that 25 percent.) For incorporated businesses or LLCs filing as an S-Corporation, this contribution would be made on up to 25 percent of your W2 wages.
• Total contributions: The maximum amount you can contribute altogether (not counting catch-up contributions) is $69,000.

Who can contribute to a solo 401(k)?

You can contribute to a solo 401(k) if you’re self-employed and do not have any employees (aside from your spouse) and you have an employer identification number (EIN).

What happens to a solo 401(k) when you’re no longer self-employed?

If you decide to make a career change and leave the self-employed life behind, you’ll no longer be able to contribute to a solo 401(k). Instead, you could roll those funds into an employer-sponsored qualified retirement plan if your new employer allows it. Those options often include:

• A traditional IRA.
• A Roth IRA. (FYI, you’ll have to pay taxes on the rollover amount, but you’ll benefit from tax-free withdrawals later on.)
• A traditional 401(k) you open with a new employer.

Is a solo 401(k) a good idea?

A solo 401(k) can be a great option if you work for yourself and have no employees. The high contribution limits can help accelerate your retirement savings, and you can also take advantage of some attractive tax benefits. On that note, the money you put in as the employer qualifies as a business expense if your business is incorporated. If that’s not the case, you might be able to claim a personal tax deduction.

What are the disadvantages of a solo 401k?

No retirement account is perfect. Here are some potential drawbacks of opening a solo 401(k):

You can’t have employees

If your business grows and you want to expand your team, you may have to make contributions to your employee accounts as well, or you’ll have to explore other types of retirement plans. (On the upside, if your spouse works for the business, you can both participate in the solo 401(k) plan. That can help boost your combined retirement savings.)

Early withdrawal penalties apply

Pulling money out early could come back to bite you. The 10 percent penalty we mentioned earlier is on top of normal income taxes.

You’re on the hook for RMDs

Unless your solo 401(k) is set up as a Roth account, you’ll eventually have to start taking annual distributions—and those withdrawals will be taxable.

They’re more complicated to open and maintain

Establishing a solo 401(k) will likely take more time and energy than, say, opening an IRA online. Your business must also have an EIN. What’s more, if the value of your solo 401(k) exceeds $250,000, you’ll probably have to file IRS Form 5500-EZ every year. You’ll also need to have an administrator for the solo 401(k), which has a fee, as well as someone to draft the formal documents needed to establish and maintain the account.

Solo 401(k) vs. SEP IRA

If you don’t have any employees, a simplified employee pension (SEP) IRA could be a good fit in some circumstances where you don’t want to contribute at a higher level and also can save on administrative fees. A solo 401(k) permits you to contribute at a higher level, as discussed above and allows for Roth contributions. However, if and when you do add employees, you need to revisit how you structure your retirement plans.

A financial advisor can help

Whether a solo 401(k) is right for you will depend on your business and retirement saving goals. It could be a solid way to shore up your nest egg and save for the future—especially if you’re a business of one.

Your Northwestern Mutual financial advisor can answer your questions and help you choose the right savings tool for you. They can also show you how other tools—like life insurance—can work alongside your retirement savings to give you even more flexibility.

This publication is not intended as legal or tax advice. This information was compiled by the advanced planning attorneys of The Northwestern Mutual Life Insurance Company. It is intended solely for the information and education of Northwestern Mutual Financial Representatives, their customers, and the legal and tax advisors of those customers. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Northwestern Mutual and its Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions.