(DailyChive.com) – If you’ve decided to start your own business, you’re now responsible for handling retirement savings on your own. Fortunately, freelancers and entrepreneurs have several tax-advantaged savings options. A solo 401(k) plan is one of the most flexible.
What is a Solo 401(k)?
A solo 401(k) is a retirement savings plan designed for business owners with no employees except for their spouses.
Contribution Limits
A solo 401(k) lets you make contributions as both an employer and an employee. The IRS adjusts contribution limits each year. This article will use 2023 numbers, but you should check with the IRS for the latest limits.
There are three parts of the contribution limit:
- As an employee, you can save up to 100% of your earning or $22,500, whichever is less. If you’re 50 or older, you can make an additional $7500 in catch-up contributions.
- As an employer, you can add up to 25% of your own earnings.
- You can save $66,000 per year in total.
If your spouse receives an income from your business, they can also make employee contributions and receive employer contributions. This essentially doubles the amount that you can save together.
Tax Benefits
You can set up your solo 401(k) as either a Roth 401(k) or a traditional 401(k). With a Roth, you won’t get any tax savings when you initially contribute to the account. However, you’ll be able to withdraw your savings and interest earnings tax-free in retirement. A traditional 401(k) is the opposite. You can deduct your contributions from your taxable income now, but you’ll need to pay taxes on that money when you withdraw it in retirement.
In general, you should decide which of these options is better based on how you expect your income and tax rate to change between now and your retirement. If you think your tax rate is higher now, a traditional solo 401(k) will give you the lowest lifetime tax burden. If you expect to increase your income and move into a higher tax bracket by the time you retire, a Roth 401(k) may be the better option. Regardless of the type of 401(k) you open, you’ll need to wait until age 59 1/2 to withdraw money without paying a penalty.
Why Should You Choose a Solo 401(k) Over Other Savings Options?
Solo 401(k)s aren’t the only retirement savings options that entrepreneurs have. Another common savings plan is a SEP IRA. A SEP IRA and a solo 401(k) both have an annual contribution limit of $66,000. However, a SEP IRA has more restrictions on how you can invest your contributions, and it’s only available as a pre-tax account. Also, SEP IRAs don’t let account owners over 50 make extra contributions. The major benefit of a SEP IRA is that it does allow you to have employees at your business. If you’re a small business owner and want to offer a retirement plan to your employees, a SEP IRA is the way to do it. Otherwise, a solo 401(k) is usually the better option.
Regular Roth or traditional IRAs are another option. They aren’t designed specifically for entrepreneurs, and they have a much lower contribution limit of $6500. However, if you don’t expect to save more than that, an IRA can be simpler to set up and administer. If you have a higher savings goal, a solo 401(k) will be a better option.
Planning for the future is important for everyone. Solo 401(k)s are a great way for entrepreneurs to build their retirement savings.
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