How a Solo 401(k) Works

When you are a self-employed worker, you have to be responsible for your own retirement savings. While traditional workers can use a normal 401(k) plan, you have to use a solo 401(k) plan. Known as a one-participant 401(k) by the IRS, this plan gives you the same benefits as an employer-sponsored plan. Learn more about how a solo 401(k) works.

How a Solo 401(k) Works

A solo 401(k) plan is basically the same thing as a typical 401(k) plan. The only difference is that it only works if you are a business owner without any employees. If you have employees, then you can’t use it. It only works if you and your spouse are the company’s only employees.

There are no age or income restrictions for this business, although you are limited to a maximum contribution of $54,000 in 2017. If you are age 50 or older, you can also contribute an added catch-up contribution of $6,000 per year. A Roth 401(k) lets you contribute with after-tax dollars, but a traditional 401(k) allows you to contribute with pre-tax dollars. To open a solo 401(k) plan, you just need to have an employer identification number. After that, all you need to do is go to an online broker to set up your plan.

You Are the Employer and the Employee

How a solo 401(k) works is by basically assuming that you are both the employer and the employee. Normally, the employer can contribute up to $18,000 or 100 percent of compensation. You can make a profit-sharing contribution of 25 percent of your compensation as the employee. Remember though: your 401(k) limits apply to all of your 401(k) plans. If you also have a standard 401(k) through a traditional employer, then you are limited by the total of your standard 401(k) and your solo 401(k) plan.

When it comes to taxes, you can benefit by reducing your taxable income. If you use a traditional 401(k), your contributions are treated like they do not exist. When you withdraw the funds after age 59.5, then you are taxed on the withdrawals.

If you get a Roth solo 401(k), then you do not get a tax break initially. Your contributions are taxed like your normal income. When you withdraw the money later on, then you get the withdrawals without any taxes on it. This option works best if you expect to have a higher income bracket when you retire.

Whichever option that you choose will be based on the Internal Revenue Service‘s rules about retirement accounts. In general, you will have to wait to withdraw funds until after age 59.5 or you will pay penalties and taxes. There are certain cases where you can withdraw your contributions and interest with a Roth, but make sure to talk to an accountant beforehand.

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