Just because you are a one-person outfit, a freelancer, or an independent contractor doesn't mean you have to go without a retirement plan. If you are self-employed, you can set up a solo 401(k), also known as an independent 401(k) plan, on your own. Solo 401(k)s have some benefits over other types of retirement accounts.

Key Takeaways

  • Self-employed individuals who meet certain requirements can set up a solo 401(k) to save for retirement.
  • This type of plan offers several benefits over other types of retirement accounts.
  • One of the main benefits is that contribution limits are typically higher than other retirement plans.

Let's start by taking a look at what is required to set one up and how they work.

Eligibility Requirements

In order to invest in a solo 401(k), you must meet certain requirements. The first stipulates that you, and not an employer, are responsible for your income. Sole proprietors, small business owners without employees (though spouses can contribute if they work for the business), independent contractors, and freelancers typically fit this description.

The second requirement is that you must have earned income. This can be verified through tax records.

If you meet both criteria, you can open a solo 401(k) plan.

Steps to Set Up a Solo 401(k)

According to the Internal Revenue Service (IRS), there are specific steps that must be taken in order to properly open a solo 401(k) plan.

First, you have to adopt a plan in writing, which means you have to make a written declaration of the type of plan you intend to fund. You can choose between two types of 401(k) plans: traditional and Roth. Each has distinct tax benefits.

A solo 401(k) must be set up by December 31 in the tax year for which you are making contributions.

The Traditional 401(k)

With a traditional individual plan, you invest your dollars pretax, effectively claiming a tax break during your working years. When you reach retirement age, you pay income taxes on the funds you withdraw—including the money your investments have earned over the years.

The downside is that when you are ready to withdraw your money, the tax rate could be higher than when you initially invested. Also, the additional tax burden might erase any tax benefits that you received previously. Keep in mind, though, that most retirees are in a lower tax bracket than they were during their working years.

The Roth 401(k)

Roth plans are funded with after-tax dollars. Since you've already given the IRS its cut, withdrawals are tax-free when it's time to retire. That's totally tax-free, both the amount you paid in and the returns the account earned.

Once the type of plan has been established, you will need to create a trust that will hold the funds until you need them or you reach retirement age. You can select an investment firm, online brokerage, or insurance company to manage the plan for you.

You also need to establish a record-keeping system, so all investments are accounted for at all times.

Benefits of a Solo 401(k)

Solo 401(k)s provide several advantages over other types of retirement accounts.

One of the main advantages is that contribution limits are typically the highest among retirement plans. Like an employer-sponsored 401(k), contributions can be made from the employee and employer. With a solo 401(k), you wear both hats and can make contributions in both roles.

Contribution Limit as an Employee

The IRS has established annual contribution limits for 401(k)s. For 2020 and 2021, the maximum contribution limit for a 401(k)—as an employee—is $19,500. If you are 50 or older, you can make an additional catch-up contribution of $6,500 for both 2020 and 2021.

Contribution Limit as an Employer

Wearing the employer hat, you can contribute up to 25% of your compensation. The total contribution limit for a solo 401(k) is $57,000 for 2020, not counting the employee's $6,500 catch-up amount for those over the age of 50. For 2021, the employer maximum is $58,000. In other words, in 2021 you can contribute $58,000 ($19,500 as an employee + $38,500 as an employer) along with a $6,500 catch-up contribution if applicable for a total of $64,500 for the year.

Added Flexibility

The ability to choose between a traditional and Roth plan is also a benefit. This means that you can choose a plan with the tax advantage that works best for you.

Another benefit is that unlike a SEP IRA, another tax-advantaged retirement account often recommended for small business owners, you can take loans from the plan. In general, it's not advisable to borrow from your retirement fund, but it's a decent option if you must.

With proper planning and diligence, a solo 401(k) offers the potential to enjoy a comfortable retirement after years of being your own boss and working on your own terms.