One of the many decisions that self-employed business owners are responsible for is choosing a retirement plan to contribute to. Several types of plans exist for self-employed workers to save for retirement in a tax-advantaged way, including SEP and SIMPLE plans. But among the various options,
The solo 401(k) plan, in its current form, came into being in 2001 when the
Later enhancements, like the
However, because of some of the requirements for solo 401(k) plan owners (also known as "participants") — such as increased paperwork and tax filing requirements, as well as a multistep calculation to determine how much can be contributed to the plan — solo 401(k) plans have acquired a reputation of being somewhat onerous to maintain, meaning that they tend to be underutilized by self-employed workers despite their many potential advantages.
For financial advisors, then, helping self-employed clients navigate the process of managing a solo 401(k) plan offers a way to unlock its value and potentially create significant amounts of tax-advantaged wealth for retirement.
How solo 401(k) plans work
Anyone who is self-employed and has no employees other than themselves (with the exception of the business owner's spouse as the only other employee) can open and contribute to a solo 401(k) plan. Conceptually, solo 401(k) plans work the same as a 401(k) plan for a larger company: The "employer" and "employee" are both allowed to make contributions on the employee's behalf. But because a self-employed person is both the employer and employee in a solo 401(k) plan, there is effectively one annual contribution with two different layers, one each for the "employee" and "employer" portion, as follows:
- For the employee's portion, the individual can contribute up to 100% of their compensation up to an annual limit ($20,500 for 2022 and $22,500 for 2023); and
- As the employer, the individual can also contribute up to 25% of their compensation.
The combined limit of the two types of contribution, along with any other qualified employer retirement plans the individual participates in, is the lesser of 100% of compensation or $61,000 in 2022 ($66,000 in 2023), plus additional catch-up contributions of $6,500 in 2022 ($7,500 in 2023) for individuals over age 50. (For the rest of this article, 2022 contribution limits will be used for simplicity's sake.)
The IRS defines compensation for the purposes of calculating a solo 401(k) plan's contribution limit as
- Calculate the earnings subject to self-employment tax (net Schedule C income or S corporation wages multiplied by 0.9235).
- Multiply the result of Step 1 by 1/2 of the self-employment tax rate (0.153 ÷ 2 = 0.0765). If the individual's earnings subject to self-employment tax are more than the Social Security wage base ($147,000 in 2022), multiply the first $147,000 by 0.0765 and the remainder by 0.0145, then add the two amounts together.
- Subtract the result of Step 2 from the individual's net Schedule C income or S corporation wages.
The steps for calculating the maximum contribution to a solo 401(k) plan are laid out in the
For the employee part of the contribution, the individual can contribute up to 100% of their net compensation (the amount calculated in Step 3 above) or $20,500, whichever is less.
Figuring the employer's allowed contribution amount requires one additional calculation: the plan's maximum contribution rate (25%) must be reduced to account for the contribution itself, which is done by dividing the rate (as a percentage) by one plus itself. In effect, then, even though the maximum employer contribution rate is 25%, the real maximum rate is 25% ÷ (100% + 25%) = 20%.
Finally, the employer portion of the contribution is also limited to the lesser of (1) the maximum allowed contribution as calculated above; (2) the difference between maximum combined limit ($61,000 for 2022) and the amount of the employee contribution; or (3) 50% of the difference between net compensation and the employee contribution.
Example 1: Larry Little is the owner and sole employee of Little Larry's Locksmithing. Larry earns $100,000 per year in net income from his business, and he establishes a solo 401(k) plan in the name of his business to save for retirement.
To determine how much Larry can contribute to his solo 401(k) plan this year, it's first necessary to calculate his compensation, i.e., his net earnings from self-employment. Following the three-step calculation above:
- Larry's earnings subject to self-employment tax are $100,000 × 0.9235 = $92,350
- One-half of the self-employment tax equals $92,350 × 0.0765 = $7,065
- Net compensation equals Larry's net schedule C income minus one-half of the self-employment tax, or $100,000 – $7,065 = $92,935.
Now it's possible to calculate the separate employer and employee contribution limits for Larry's solo 401(k) plan, which combined will give the maximum amount that he can contribute to his plan overall.
Employee contribution: The lesser of $20,500 or 100% of compensation (which is $92,935, as calculated above). The smaller number is $20,500, so that is the maximum employee contribution.
Employer contribution: Up to 25% of compensation, adjusted for the contribution itself. The maximum allowed employer contribution is 0.25 ÷ (1 + 0.25) × $92,935 = $18,587.
The difference between the maximum combined limit and the amount of the employee contribution is $61,000 – $20,500 = $40,500.
Fifty percent of the difference between net compensation and the employee contribution is 0.5 × ($92,935 - $20,500) = $36,217.50
The maximum employee contribution is the lesser of these three totals, which is $18,587.
Total contribution: The lesser of $61,000 or the sum of the employee and employer contributions ($20,500 + $18,587 = $39,087). $39,087 is the smaller number, so that is Larry's maximum allowed total contribution.
As with other types of 401(k) plans, the employer portion of a solo 401(k) plan contribution is always pretax — that is, it is excluded from the participant's gross income. However, the employee portion can be directed into either a pretax (traditional) account or a Roth account. The employee contribution can be either entirely pretax or entirely Roth, or a combination of both, as long as the total combined pretax and Roth employee contributions don't exceed the employee contribution limit of $20,500 or 100% of compensation, whichever is smaller.
In addition to the standard employee and employer contributions, there is a third layer of contribution possible for solo 401(k) plans: nondeductible employee contributions. Unlike traditional and Roth contributions, nondeductible contributions have both a pretax and an after-tax component: While the contribution itself is included in the participant's gross income and can be withdrawn tax free, any subsequent growth on the account is tax deferred and is taxed upon withdrawal.
Why would someone want to make nondeductible contributions to a solo 401(k) plan? First, nondeductible contributions aren't subject to the $20,500 limit for pretax and Roth employee contributions; rather, they can be made all the way up to the limit for all combined contributions, i.e., the lesser of 100% of compensation or $61,000. Which means that participants can use nondeductible contributions to max out their total contributions when they would otherwise be limited by the standard employee and employer contribution limits.
Example 2: Larry, from Example 1 above, wants to maximize his solo 401(k) plan contributions with after-tax funds.
Larry has already made a contribution of $20,500 (as employee) + $18,587 (as employer) = $39,087.
Because he can contribute up to a total of $61,000, Larry makes a nondeductible contribution of $61,000 – $39,087 = $21,913.
A second upshot of making nondeductible contributions to a solo 401(k) plan is that participants can convert the after-tax portion of the contribution into a Roth account while rolling any pretax dollars into a traditional account – i.e., the
Example 3: Imagine that Larry, from the examples above, wants to make the maximum contribution to his solo 401(k) plan entirely in the form of Roth contributions.
Larry can first make the maximum standard employee contribution of $20,500, electing to contribute those funds to a designated Roth account.
Then, Larry can make the remainder of his maximum combined contribution, or $61,000 – $20,500 = $40,500, in the form of a nondeductible employee contribution.
Finally, Larry can convert the after-tax funds into a Roth account by rolling them into his designated Roth account. He has now effectively made a $61,000 Roth contribution to his solo 401(k).
Note: While Larry could also simply make $61,000 in after-tax contributions and then convert the entire contribution into a Roth account rather than making both an after-tax and a standard Roth contribution. However, if the value of the after-tax account grows at all in between the contribution and the conversion, that growth (which would be treated as pretax) would be split off into the pretax portion of the account. If part of the contribution were instead made directly into the Roth account, then any growth of those funds would simply retain their tax-free Roth treatment, reducing the potential for growth of contributed after-tax funds from being recategorized as pretax funds prior to conversion.
Advantages of solo 401(k) plans
Solo 401(k) plans have several features that make them stand out from other types of self-employed retirement plans, like Simplified Employee Pension (SEP) plans or SIMPLE IRAs.
First is the ability to contribute a higher percentage of one's income to the plan. While all workers, regardless of the type of employer retirement plan, are generally limited to a total of $61,000 (in 2022) in combined employee and employer contributions, the amount of income an individual must earn to be able to reach that maximum contribution limit changes based on the type of plan.
For example, SEP contributions are capped at 20% of the participant's net self-employment income. This is effectively the same as the employer portion of the solo 401(k) plan contribution, but the additional employee portion allowed by the solo 401(k) plan — which can be 100% of compensation up to $20,500 — means that solo 401(k) plan participants can contribute a much higher percentage of their income if they don't earn enough to max out the employee portion alone.
Specifically, in order to contribute the maximum of $61,000 to their plan, a SEP participant must earn $321,000 in self-employment income — whereas a solo 401(k) plan participant need only earn $217,000 to contribute that amount using standard employee and employer contributions, or just $67,000 when using nondeductible contributions, as shown below.
SIMPLE IRAs work similarly to solo 401(k) plans in that they also have an employee and employer component to the contribution, but both SIMPLE IRA portions have lower limits than those of solo 401(k) plans. For SIMPLE IRAs, the employee portion is limited to $14,000 in 2022 (versus $20,500 for solo 401(k) plans), while the employer contribution is capped at 3% of net self-employment income (versus 20% for solo 401(k) plans). For SIMPLE IRAs, the contribution limits lag behind solo 401(k) plans at incomes above $14,000 and behind SEPs at above $90,000.
One of the best use cases for a solo 401(k) plan, then, is for an individual who wants to save at a (potentially much) higher rate than a SEP or SIMPLE IRA would allow for their income level.
Another advantage of solo 401(k) plans is the ability to include a designated Roth account feature, allowing the plan participant to make both pretax and Roth contributions (keeping each type of contribution separate within the plan). As described above, solo 401(k) plan participants can allocate part or all of the employee portion of their contribution to a Roth account (the employee portion must remain pretax, no matter what). The upshot is that — like employees of larger companies whose 401(k) plans include a Roth option — solo 401(k) plan owners can make up to $20,500 in designated Roth contributions, with no income limits.
The unique challenges of setting up and managing solo 401(k) plans
While solo 401(k) plans can offer higher contribution potential and increased flexibility to make Roth or after-tax contributions, the flip side is that they can also come with greater administrative complexity to implement and maintain than other types of retirement plans.
This is because, in the eyes of the IRS, solo 401(k) plans are the exact same type of entity as the standard 401(k) plans offered by larger employers. And although they are exempt from
- The adoption of a written plan document;
- Filing Form 5500-EZ when plan assets exceed $250,000; and
- Meeting the required deadlines for establishing and contributing to the plan.
It's worth going into more detail on the above to better understand the requirements for solo 401(k) plan owners and what elements of the plan they must either manage themselves or outsource to a third party.
The written plan document
In a nutshell, the plan document for a solo 401(k) plan — and for bigger employers' 401(k) plans, for that matter — is a broadly written description of the plan's provisions, including who is eligible to participate; how the plan handles contributions, distributions, and loans; and rules for vesting and forfeiture of participants' assets.
The main purpose of the plan document is to ensure that the plan complies with IRS and/or ERISA rules wherever applicable. Plan documents tend to be written by solo 401(k) plan providers in generic legal boilerplate so as to apply to as many different individual plans as possible; however, they often aren't that useful at communicating practical information about the plan itself. Much of the language used in the plan document is broad and nonspecific, so determining how the plan actually works in practice can be difficult to determine from the plan document alone. For example, a plan document might state that the plan "may allow" participants to make Roth contributions or take out loans from the plan (because the IRS says that qualified plans may allow these features), when in reality the plan itself may not actually allow Roth contributions or participant loans. So when setting up a new solo 401(k) plan or reviewing an existing plan, the plan document itself won't necessarily be the most useful source for finding out the plan's specific features.
The place where those features can be found is typically in the plan's adoption agreement, a shorter form that typically accompanies the plan document. Numerous key features of the plan are outlined in the adoption agreement, including:
- The plan's effective date;
- Age and service time requirements for participants (though obviously self-employed individuals aren't likely to place any restrictions on their eligibility to participate in their own retirement plan);
- Types of contributions allowed (e.g., employer and employee contributions and Roth and/or nondeductible deferrals for employees); and
- Allowability of participant loans from the plan.
Form 5500-EZ
All solo 401(k) plans with assets over $250,000 as of the end of the plan year are required to file
Although filing Form 5500-EZ is a relatively simple process, it is common to find business owners who have forgotten to file by the deadline. This can be a costly mistake: The IRS imposes a steep penalty of $250 for each day after the deadline that the form is filed, up to a maximum of $150,000. However,
Still, this is a hefty price to pay compared to the amount of time it takes to prepare and file Form 5500-EZ, so for advisors with clients who own solo 401(k) plans near or above the $250,000 filing threshold, sending out a reminder for those clients to prepare and file the form in late spring or early summer could be a valuable nudge.
Plan establishment and contribution deadlines
Solo 401(k) plans must be established by Dec. 31 of the first plan year for which they are effective. For example, in order to make contributions to a solo 401(k) plan for 2022, the plan must be established by Dec. 31, 2022.
The contributions themselves, however, don't need to be made until the individual tax filing deadline of April 15, or Oct. 15 with a six-month extension.
Two approaches to setting up and managing a solo 401(k) plan
Solo 401(k) plan participants usually don't write their own plan documents — they rely on third parties to draft template documents to ensure they comply with applicable laws and regulations. Generally, there are two ways that participants go about obtaining and adopting plan documents: They use a prewritten set of documents provided by a financial institution (which could be called the off-the-shelf approach) or they hire a third-party provider to write the documents to their specifications (i.e., the self-directed approach). Understanding the mechanics and potential benefits and drawbacks of each approach can help individuals better select a plan that meets their needs.
Off-the-shelf approach: The individual goes to a financial institution, such as a broker-dealer, which provides a prewritten and IRS-approved solo 401(k) plan document along with an adoption agreement. The business owner fills these forms out and signs them to establish the plan. The individual signs another form naming the financial institution as the custodian of the plan (more on this later), then opens an account at the institution, funds their contributions, and invests the assets.
If someone wanted a solo 401(k) plan that required little more effort than going to the grocery store and picking a box of cereal off the shelf, this is the type of plan they would choose. It has the convenience of working with a single vendor who handles all of the plan's design decisions, saving the individual some of the mental load that comes with more customized plans.
Also, because the financial institutions providing the plans are generally earning revenue from them in other ways – e.g., by the client investing in the company's mutual funds, or by earning income from trading commissions, payment for order flow, or the spread on cash deposits from the client's account – there tend to be few direct costs to the business owner for setting up and administering these types of plans.
However, the benefits of convenience and low (direct) fees that off-the-shelf plans offer can come with a downside in the form of an inability for participants to customize their plans for their own needs. Financial institutions streamline their plan administration capabilities as much as possible to be able to offer them at scale, and so they tend to be fairly rigid about the features of the plans that they offer. As a result, some institutions don't allow options such as Roth or after-tax contributions that business owners may want to have in their solo 401(k) plans.
With the off-the-shelf approach, the business owner (or often in practice, the advisor they work with) generally handles the administrative aspects of maintaining their solo 401(k) plan. The custodian may provide tax forms like 1099-Rs for plan distributions and rollovers, but the participant is responsible for other actions like determining the amount of their contribution and filing Form 5500-EZ (for plans with assets over $250,000).
The key takeaway from the off-the-shelf approach is that it can provide some upfront convenience and cost savings when setting up the plan — however, the participant is generally stuck with whatever boilerplate options the financial institution decides to provide, and on an ongoing basis, the participant is on the hook for most administrative tasks required to maintain the plan and stay compliant with IRS regulations.
Self-directed approach: Instead of opting for the less flexible off-the-shelf approach, a self-employed individual may want to create a more customized set of solo 401(k) plan documents with features tailored specifically to that individual's desires. In addition to having more flexibility than an off-the-shelf plan on options like Roth features, after-tax contributions and plan loans, this approach may also allow an individual to use their solo 401(k) plan to invest in alternative assets that many off-the-shelf providers don't allow, like real estate, hard assets (e.g., gold and silver) and cryptocurrency.
Most significantly, however, a self-directed solo 401(k) plan gives the business owner the most control over how their plan is managed over time, since it isn't at the discretion of an off-the-shelf provider that can change aspects of the plan at their own whims.
When implementing a self-directed solo 401(k) plan, an individual would typically hire a third-party, self-directed solo 401(k) plan provider, who would handle the creation of the plan document and adoption agreement. The provider may also take on additional duties for the ongoing management of the plan, like keeping records of contributions and withdrawals, preparing and filing Form 5500-EZ annually (when plan assets exceed $250,000), and facilitating transactions like Roth conversions and rollovers. However, there is no single defined set of duties for a solo 401(k) plan provider, so it's important to understand which duties are the responsibility of the provider and which are the responsibility of the business owner.
Compared to the off-the-shelf approach, which tends to be centered around the financial institution that provides the plan documents and takes custody of the plan assets, the self-directed approach is often more decentralized. Individuals can open checking accounts in the name of the plan (or more accurately, in the name of a trust on behalf of the plan), which are then used to fund brokerage accounts for traditional investments, purchases of real estate or alternative investments, or crypto exchange accounts for crypto assets. Rather than relying on a single custodian for plan assets, the business owner can choose where to hold and invest their funds.
Notably, when a business owner chooses a self-directed 401(k) plan, they are responsible for keeping traditional, Roth and after-tax assets separate from each other. This typically involves opening separate accounts for each type, and not commingling funds for purchases of assets such as real estate.
Establishing a self-directed 401(k) plan
The upshot here is that, even for individuals who aren't planning to invest in any alternative assets, a
For example, even though Schwab's off-the-shelf 401(k) plan doesn't allow Roth contributions, a solo 401(k) plan owner can establish a self-directed solo 401(k) plan that does allow Roth contributions, then open a Schwab trust brokerage account in the plan's name to invest the plan's funds in (with instructions for the custodian to treat the accounts as tax-free, which is done when filling out the account opening paperwork, so they do not report any dividends, interest or capital gains generated in the account to the IRS). The only difference between this approach and an off-the-shelf plan is that with the off-the-shelf plan, Schwab would provide the plan documents and provide (limited) administrative support and recordkeeping, while with the self-directed plan, Schwab would provide only the trust account(s), and the business owner would need to handle the rest on their own (or hire a third party to do so).
Additionally, self-directed solo 401(k) plans cannot invest in life insurance contracts, nor can they invest in "collectibles"
Because of the addition of a third party to the mix, the possibility of holding investments in multiple locations rather than a single custodian, and the need to be aware of the rules for prohibited transactions and disallowed assets, self-directed solo 401(k) plans naturally come with more complexity than off-the-shelf plans.
The self-directed approach may involve more costs than off-the-shelf plans as well: Plan providers often charge several hundred dollars for the initial plan setup and annual plan maintenance fees (which can generally be deducted as business expenses on Schedule C or Form 1120S).
There is an additional cost in time and hassle, however, since compared to an off-the-shelf plan — where a broker-dealer handles the administration of the plan as well as providing the investment accounts and also serves as a single point of contact for customer support service — a self-directed solo 401(k) plan may have multiple points of contact that require more time to track down the right source of information for a question. And when more than one of those contacts need to coordinate with each other to provide an answer, the time cost increases even more.
When choosing between an off-the-shelf solo 401(k) plan and a self-directed plan, then, the biggest issues to consider (in descending order of importance) are:
- Which types of option(s) are needed (e.g., Roth or after-tax contributions, allowance of participant loans, ability to choose investment options);
- How much simplicity or complexity is desired (e.g., is it more important to have a single point of contact for all things relating to the plan, or is adding a third-party administrator acceptable?); and
- What fees and other costs are involved (e.g., if multiple options fit the needs for a plan based on options No. 1 and No. 2, which will do so for the lowest total cost?).
Choosing A Solo 401(k) Plan Provider
After
Most major broker-dealers offer an off-the-shelf solo 401(k) plan option, including those broker-dealers who serve as custodians for many financial advisors. In that light, what might seem simplest would be to use the off-the-shelf plan offered by the custodian where the advisor's other clients are already located.
Among other options,
Among the major off-the-shelf solo 401(k) plan providers,
It's also worth noting that, like TD Ameritrade, E*Trade has been acquired in recent years (merging with
The basic services of major self-directed plan providers generally include a set of initial plan documents preapproved by the IRS, as well as any required updates or restatements of the plan (
Choosing a self-directed plan provider, then, tends to come down to three main factors:
- The amount of support they offer in terms of assisting with paperwork, transactions and tax filing;
- The quality and responsiveness of customer service; and
- The fees they charge.
Fees vary broadly across the options, although generally providers with higher initial setup fees charge less on an ongoing basis. So while, for example, an individual enrolling in a Nabers Group plan would pay nothing upfront to set up (compared to other options whose startup fees range from $285-$650), they would pay more per year on an ongoing basis at $588 versus the other options that charge $125-$360 per year — which being an ongoing rate rather than a one-time setup fee, could make it significantly more expensive over the life of the plan.
The key consideration as a financial advisor, then, is how involved the client (and the advisor) desires to be in the process of setting up, funding and administering the solo 401(k) plan. If the advisor is able to support the client on things like preparing account, transfer and rollover forms as well as other administrative items like calculating and tracking contributions and knowing when and how to file Form 5500-EZ, there may not be as much need to enroll with one of the more expensive full-service options. In this sense, providing this support as an advisor represents a substantial value-add for the client, since it might save the client hundreds of dollars per year over multiple years (and possibly decades) on the more expensive solo 401(k) plan providers.
Although solo 401(k) plans can be somewhat more complex to manage than other types of investments, the value they provide in the flexibility of features and the ability to build up tax-advantaged savings can make them more than worth the effort required to set up and manage.
This combination — high value and high complexity — is the type of situation where financial advisors can thrive. Helping self-employed clients navigate the broad landscape and potential pitfalls of establishing and managing a solo 401(k) plan, delivering plans to those clients with the features they need, and working to maximize the plan's benefits each year, is the perfect example of the type of value that clients can see on an ongoing basis.
