When you are self-employed, your primary options for a retirement fund are an IRA, a SEP IRA, or a solo 401k. Of those three options, an IRA is by far the most common. The least common is a solo 401k — but for many people, the solo 401k may actually be the best choice. Many people just aren’t aware of the advantages that a solo 401k has over other retirement plan options. And even fewer people are aware of the additional advantages of a self-directed solo 401k.
By the way, the name 401k refers to the tax code that defines it. It is defined in the US tax code section 401, subsection “k”. In this article we’re using the simpler form “401k” rather than “401(k)” for readability.
First, let’s get some requirements out of the way:
- You must have self-employment income to open a solo 401k. It can’t be W-2 income. And it must be “earned” income, not passive income. Rental income that you report on a Schedule E doesn’t qualify as earned income. But you do qualify if you have Schedule C income (a sole proprietorship). Or it can be income from an S corp or C corp that you own and actively participate in. Or a partnership where you are a general partner, and you actively participate in the business.
- If at some point in the future you no longer operate your business, you have to close the 401k and roll your funds from it into another retirement account, such as an IRA.
- You can’t have any W-2 employees (other than your spouse) in any business that you own. If you have any employees, you can’t start a solo 401k. If you open one and then later hire an employee, you’ll need to transfer the assets of the 401k to an IRA (such as a self-directed IRA) and terminate the solo 401k plan.
If you don’t meet those qualifications, a solo 401k plan isn’t the retirement plan for you. Otherwise, read on.
Solo 401k vs. an IRA
Let’s first list the disadvantages of a 401k compared to an IRA:
- IRAs allow penalty-free early distributions for these specific situations that 401k plans don’t: qualified education expenses, first-time homebuyers (up to $10,000), and health insurance premiums while you’re unemployed. But a 401k does allow penalty free withdrawals during “financial hardship.”
- Contributions to a Roth IRA can be withdrawn without penalty (the original contributions only, not earnings), even if the owner hasn’t reached retirement age, as long as the account is at least 5 years old. 401k plans don’t offer that option.
Now that’s out of the way, let’s look at the advantages of a 401k (because there are some massive advantages!):
- Very high contribution limits. For 2023, the contribution limit is $66,000 (or $73,500 if you are 50 or older). Or you and your spouse both contribute, your total contribution could be as much as $147,000!
- The ability to loan money to yourself for any purpose from your 401k (up to $50,000).
- Unlike IRAs, 401k plans are exempt from paying unrelated debt financed income tax (UDFI) if you invest in investment deals that generate UDFI.
- A solo 401k can have a Roth option if you want it to be taxed like a Roth IRA (no deduction for contributing, but withdrawals are tax-free).
- The option to have a truly self-directed 401k account where you are the trustee/administrator (unlike a “self-directed” IRA, which requires you use an outside trustee/administrator which always involves added fees).
If you don’t have any employees, a self-directed solo 401k is the much better option, it made the SEP obsolete for self-employed people once it became available. You would only want to get a SEP if you have employees and can’t get a solo 401k. A solo 401k does everything a SEP does (lowering your AGI, etc.). But some of the advantages of a 401k over SEP include higher contribution limits, full checkbook control to invest in anything you want without administrator fees, the option to make loans to yourself from it, the option to have a Roth-designated account for Roth contributions, and other advantages. It’s easy to set up an account.
If you want to only invest in stocks, bonds, and mutual funds, you can create a non-self-directed solo 401k account with a brokerage or financial platform such as Vanguard or Fidelity. It’s simple to create an account, and they’ll administer it for you. But you do also have the option to create a self-directed 401k instead.
Using a Self-Directed Solo 401k
There’s a whole other level of possibilities that open up if you choose to have a self-directed solo 401k that gives you full checkbook control of your investment funds. Unlike with IRAs, you are allowed to be the administrator of your own 401k account. That allows you to open a bank account in the name of the 401k trust, and then write checks to invest in almost anything, including real estate, cryptocurrency, syndicated investments, and private lending. Unlike a self-directed IRA, there is no middle-man administrator to ask for approval (or to pay transaction fees to).
Be aware that with the power of being the administrator of your own retirement account, there are some responsibilities that come with that. The first is that you must make sure that your use of the funds follow the rules (including things like not investing in things that you personally benefit from, such as investing in your own business, or buying a property from yourself). A prohibited transaction could jeopardize the tax-advantage status of your 401k assets.
You’re also responsible for filing any required tax forms, in particular the form 5500-EZ if your 401k plan holds more than $250,000 in assets. It’s not difficult to do, and you or your tax professional can take care of that.
To create a self-directed solo 401k, first you must create the plan documents that establish the plan along with a trust to hold the assets. There are service providers that will create the plan documents for you and provide you with step-by-step instructions and support to get you started. Reputable providers that offer that service include My Solo 401k and Discount Solo 401k.
