One doesn’t have to be the loneliest number anymore. For years, sole
proprietors weren’t able to choose from as wide a range of retirement
plan options as bigger operations could. Or, in the case of a 401(k)
plan, the administrative costs would outweigh the potential benefits
in the business owner’s eyes.
But the landscape has changed dramatically over time. Currently, you
have a myriad of choices at your disposal, including setting up and
maintaining a “solo 401(k)” for you—and just you alone—at a reasonable
cost.
Basic premise: A solo 401(k) plan works pretty much like a traditional
401(k). For starters, you can elect to defer part of your salary to
your account within generous annual limits. For 2022, the maximum
deferral is generally $20,500, plus you can tack on a catch-up
contribution of up to $6,500 if you’re age 50 or over, for a grand
total of $27,000.
This money contributed to the plan is then invested and can grow and
compound within your account on a tax-deferred basis.
But there’s more: A business owner may add matching contributions as
the employer up to the current tax law limits for defined contribution
plans. The total deductible contributions for 2022 can’t exceed the
lesser of 25% of compensation or $61,000, increased to $67,500 if
you’re age 50 or over. The maximum compensation taken into account for
these purposes in 2022 is $305,000.
This unique combination enables you to build up a nest egg retirement
even if you are getting a late start.
Note that a self-employed individual must make a special computation
to find the maximum amount of elective deferrals and nonelective
contributions. In figuring the contribution, your compensation is your
“earned income.” This is defined as net earnings from self-employment
after deducting one-half of your self-employment tax and contributions
for yourself. Rely on your professional advisors for guidance.
Of course, strict testing requirements can be a headache for
traditional 401(k) plans, but it is usually less of a hassle for solo
plans. Notably, a business owner with no other employees doesn’t need
to perform any nondiscrimination testing for the plan. Reason: There
are no employees who might be receiving disproportionately high
benefits.
Typically, a solo 401(k) plan may offer other advantages, such as the
ability to borrow from your account or to take hardship withdrawals
under extenuating circumstances. If you’ve worked somewhere else and
built up savings in a 401(k) or other qualified retirement plans, you
can generally roll over those funds tax-free into your solo 401(k).
And contributions to the plan are discretionary, so you have more
leeway in a year in which the business is struggling.
Finally, be aware you can use a Roth version of a solo 401(k). With
this setup, you contribute after-tax proceeds to your account but
you’ve secured the ability to take tax-free payouts in the future.
Otherwise, distributions from a solo 401(k) plan are subject to
ordinary income and the 10% penalty for early withdrawals, the same as
a regular 401(k).
The choice is yours: Consider all the possibilities.