Understand how a regular and solo 401(k) compare, who can have them, and ways to maximize their tax-advantaged benefits.
Understand how a regular and solo 401(k) compare, who can have them, and ways to maximize their tax-advantaged benefits.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Matt M. says, "Hi, Laura. Your podcast has been a valuable source of financial education. I've listened to various episodes but am unsure if I can use a solo 401(k). Can you review how to utilize this type of account?"
Matt, thanks for sending in your question! I'll review solo 401(k) rules and how it compares to a regular 401(k). You'll learn who qualifies for these similar-sounding yet different tax-advantaged accounts and how to maximize their benefits.
Hi, everyone, and thanks for joining me this week! I'm Laura Adams, a personal finance expert hosting the Money Girl Podcast since 2008, with over 42 million downloads.
I’m the founder of The Money Stack, a weekly newsletter helping you build your bank account and live rich on your terms. I also work with select brands doing on-camera and writing work as a financial spokesperson and female money speaker.
As always, you can reach me using my contact page at LauraDAdams.com. That's also where you can learn more about my newsletter, books, and money courses. Got a money question or idea for a show topic? Call 302-364-0308 and leave me a message.
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What is a 401(k)?
A 401(k) is a popular type of tax-advantaged retirement plan that an employer can offer. And if you're self-employed, you may choose a similar account called a solo 401(k). They allow you to contribute a portion of your paycheck or self-employment income and select investment options, such as mutual funds and exchange-traded funds (ETFs), to accelerate your account growth.
With either type of 401(k), you can usually choose a traditional or Roth account.
Traditional accounts give you an immediate benefit with tax-deductible contributions, which reduce your annual taxable income and tax liability. You defer paying income tax on contributions and account earnings until you take withdrawals in the future.
Roth accounts require you to make taxable contributions. However, your future withdrawals of contributions and investment earnings are entirely tax-free.
Unlike a Roth IRA, which has an income limit to qualify, there's no income threshold to participate in a Roth 401(k) or Roth solo 401(k). Therefore, even high earners can participate in a workplace or self-employed Roth and reap the benefits.
LISTEN ALSO: Too rich for a Roth? 3 legal ways to have one
Differences between a 401(k) and a solo 401(k)
Now that you understand the 401(k) basics, let's cover six main ways a regular and solo plan differ and answer Matt's question.
1. Administration.
If you're a business owner, there's a financial and administrative cost to offering your employees a 401(k) retirement plan. The brokerage firm you choose charges fees to set up and administer a plan as your custodian. Plus, employers have a fiduciary duty to act in the best interest of their workers and follow the federal Employee Retirement Income Security Act (ERISA).
The solo 401(k) was designed to be easier to administer and less expensive for the self-employed. Unless your plan exceeds $250,000 in assets, no filing requirements exist. But when your account exceeds that amount, you must file Form 5500-EZ, a simple, two-page document.
2. Eligibility
You can only participate in a 401(k) when your employer offers one. While most large companies offer a retirement plan, it's not required. They come with administrative costs that prevent many small businesses from offering a retirement plan.
You can only have a solo 401(k) if you're self-employed with no full-time employees except a spouse or business partner. For instance, you might work part-time or full-time as a freelancer or contractor or have a side business like real estate, tutoring, photography, or writing.
The business owners and their spouses are considered owner-employees rather than employees but can also contribute to their own solo 401(k) plans. Interestingly, you contribute as both an employer and employee of your business, increasing the annual contribution limit, which we'll cover next.
Matt, a solo 401(k) is an excellent choice if you're a solopreneur with no plans to hire full-time staff. You can have one even if you work another job.
For instance, if you have a W-2 day job and a part-time side business with 1099 income, your business income makes you eligible for a solo 401(k) no matter how much or little you earn. However, you can’t contribute more than your self-employment earnings.
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3. Contribution limits
The contribution limits differ significantly between a regular and solo 401(k). As I mentioned, the solo rules allow you to contribute as if you were two people: an employer and an employee of your own business.
For 2023, those with a regular 401(k) can contribute up to $22,500 or $30,000 if they're over 50. Your employer may make additional matching or profit-sharing contributions to your account, allowing you to exceed those limits. For 2024, the limits increase to $23,000 or $30,500.
If you have a solo 401(k), the annual contribution limits are much higher but depend on your business income. For 2023, the combined employer and employee contribution limit is up to $66,000 or $73,500 if you're over 50. After age 50, you automatically qualify for an additional $7,500 catch-up contribution.
Let's break down the solo 401(k) contribution rules. You can contribute up to $22,500 or $30,000 as your employee. Plus, as your employer, you can make an additional profit-sharing contribution of up to 25% of your income, up to the $66,000 or $73,500 annual maximum. So, the more you earn, the more you can contribute to a solo 401(k).
Note that if you have a regular 401(k) with another employer, you can also have a solo 401(k). However, the employee limits apply per person, not per plan. That means you can't exceed the employee limit of $22,500 or $30,000 if you're over 50 for 2023, no matter how many 401(k)s you have.
READ ALSO: Your complete guide to 401(k) retirement accounts
4. Investment options
With a regular 401(k), the plan rules, investment options, and fees are determined by your employer. Some brokerage firms may offer an extensive investment menu, and others may be slim.
As your own employer with a solo 401(k), you have more control over the investment options and fees. So, whether you want to purchase stock, mutual funds, ETFs, gold, or cryptocurrency in your retirement plan, you'll find providers offering mainstream and alternative investments with varying fees. You could open a self-directed solo 401(k), allowing you to invest in almost anything tax-free, including real estate, tax liens, and private business funding.
LISTEN ALSO: 4 ways to start a retirement account as a self-employed freelancer
5. Loans
Some regular and solo 401(k)s offer participants loans and hardship withdrawals, while others don't. If you're under age 59.5, a 401(k) withdrawal is subject to income taxes plus a 10% penalty.
If your regular or solo 401(k) allows loans, the IRS allows you to borrow up to 50% of your account value up to a lifetime limit of $50,000. You can use the funds for any purpose but must repay yourself at a set interest rate for up to five years.
If you don't repay a regular or solo 401(k) loan on time, it could be considered an early withdrawal, subject to income taxes, plus an additional 10% early withdrawal penalty. However, if you pay it on time, a 401(k) loan is tax-free, regardless of age.
READ ALSO: Should you raid your 401(k)? Know the pros and cons
6. Legal protections
I mentioned that ERISA, a federal law, protects regular 401(k)s. It sets minimum standards for employers that offer retirement plans and the administrators who manage them. It protects plan participants and their beneficiaries' interests in workplace retirement plans.
Additionally, a powerful but lesser-known benefit ERISA offers workplace retirement plans is protection from creditors. Let's say you have money in a regular 401(k) but lose your job and can't pay your car loan. The car lender can attempt to get repayment from you in various ways, but not by tapping your 401(k). There are exceptions like owing federal tax debts, criminal penalties, or an ex-spouse under a Qualified Domestic Relations Order.
But a solo 401(k) isn't covered under ERISA because they aren't considered an employee benefit plan. Since they only cover business owners and their spouses, a solo 401(k) doesn't enjoy the same legal protections as a regular 401(k) protected by ERISA.
Therefore, if you're considering a rollover from an old 401(k) to a solo 401(k), be aware that you wouldn't enjoy the same legal protections from potential creditors.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.
Money Girl is a Quick and Dirty Tips podcast. It's audio-engineered by Steve Rick-E-Berg. Our Director of Podcasts is Brannan Goetschius, our digital operations specialist is Holly Hutchings, our advertising operation specialist is Morgan Christianson, and our marketing and publicity associate is Davina Tomlin.