A Solo 401(k) is a retirement account designed for self-employed individuals or small business owners with no full-time employees other than themselves and their spouse. While you must be self-employed and have no employees other than your spouse to be eligible for this account, if you qualify, they can be extremely useful for self-employed investors. A Solo 401(k) is sometimes considered the most sought-after account.
Employer vs Employee Solo401(k)
With a Solo 401(k), you can make contributions as both the employer and employee. As the employee, you can contribute up to 100% of your earned income, up to the annual contribution limit (click here to see the contribution limits for Solo 401(k)s). As the employer, you can make additional contributions up to 25% of your net self-employment income. One of the advantages of a Solo 401(k) is that you can make larger contributions than you could with other types of retirement accounts, such as a traditional or Roth IRA. Additionally, the contributions you make to a Solo 401(k) are tax-deductible, meaning you can reduce your taxable income for the year.
Unrelated Business Taxable Income
Another benefit of a self-directed 401(k) is provides an exemption from Unrelated Business Taxable Income (UBTI), which includes Unrelated Debt-Financed Income (UDFI). UDFI refers to income that is generated by debt-financed assets that are held within a tax-exempt entity, such as a retirement account. This type of income can be subject to UBTI tax, which can significantly reduce the investment returns within your retirement account. However, if you set up a Solo 401(k) plan, you may be able to avoid UDFI and UBTI tax altogether. It’s important to note that while a Solo 401(k) can provide exemption from UDFI and UBTI tax, you should still carefully consider any debt-financed investments and ensure that they align with your overall investment strategy and risk tolerance.
Checkbook Control over Your Account
A unique, and arguably the most sought-after, feature of a Solo 401(k) is that it allows you to have checkbook control over your retirement funds. Checkbook control is the ability to
write checks directly from your retirement account to make investments making you able to
- pay expenses
- manage your retirement funds.
- have direct access to your retirement funds, which can provide greater flexibility.
If you find a real estate investment opportunity you want to pursue, you can write a check directly from your Solo 401(k) to fund the investment, rather than having to go through a custodian or administrator. Having checkbook control also means that you can make investments quickly and efficiently, without having to wait for approval from a custodian or administrator. This can be particularly useful if you’re investing in time-sensitive opportunities, such as real estate or private equity deals.
In order to have checkbook control over your self-directed 401(k), you’ll need to
- Set up a separate bank account for your retirement funds, known as a “Solo 401(k) checking account”.
- Ensure that you follow all IRS rules and regulations for managing your retirement funds, including maintaining accurate records and avoiding prohibited transactions.
- Familiarize yourself with IRS rules and regulations.
It’s important to note that checkbook control can come with some risks. Improper use of checkbook control could result in significant tax penalties and other legal consequences. Therefore, it’s important to work with a qualified financial advisor or tax professional who can help guide you through the process and ensure that you’re following all applicable rules and regulations.
While having more control over your retirement savings and investment decisions is a major benefit of a Solo 401(k), it also comes with additional responsibilities that must be carefully managed. As the plan administrator of a Solo 401(k), you’re responsible for ensuring that the plan is properly established, maintained, and administered. This includes keeping accurate records, filing annual reports with the IRS, and ensuring that all plan contributions are made on time. The reporting requirements and administrative responsibilities associated with a Solo 401(k) plan can be seen as a potential negative for some self-employed individuals.
Setting up and managing a Solo 401(k) plan requires time and effort. You’ll need to carefully consider the plan design, choose a custodian or trustee, and ensure that all plan contributions and distributions are properly recorded and reported. For some self-employed individuals, this additional administrative burden can be a barrier to setting up a Solo 401(k). You’re responsible for ensuring that the plan is fully compliant with all IRS regulations. This includes filing annual reports with the IRS, making timely contributions, and ensuring that all plan investments are permissible. If you fail to comply with these regulations, you could face significant penalties and tax consequences.
Opening a Solo 401(k)
It’s important to note that a Solo 401(k) has some administrative requirements and may require additional paperwork, such as filing an annual Form 5500-EZ with the IRS if your plan has more than a certain amount in assets. As always, it’s a good idea to consult with a financial advisor or tax professional before setting up a Solo 401(k) to ensure that it’s the right retirement account for your specific needs and goals.
Do you want to learn more about employer plans or the contribution amounts for them? Read more about self-directed 401k, SEP IRA, and SIMPLE IRA contribution limits for 2023. We would also love to talk to you if you are interested in starting a Solo 401(k), so schedule your free consultation with an IRA Specialist today.