What Is a Self-Employed 401(k) Plan?

Self-Employed 401(k) Plan Explained in Less Than 4 Minutes

Small business owners
•••   Hero Images / Getty Images

A self-employed 401(k) plan is a retirement plan for small business owners who are the only employee (besides a spouse) of their business. The small business owner can make contributions for both employee and employer.

Learn more about self-employed 401(k)s and how one can be used to plan for your retirement.

Definition of a Self-Employed 401(k) Plan

A self-employed 401(k) is a traditional 401(k) that sole-proprietors and their spouses can set up to save for retirement. Since business owners work for themselves, they don't have an employer with an established pension plan, retirement fund, or plan to contribute to and take with them.

Alternate name: Solo 401(k) Plan, One-participant 401(k) Plan, Uni-k, Solo-k

How a Self-Employment 401(k) Plan Works

Self-Employed 401(k)s allow small business owners with no other employees to contribute to a retirement plan as an employee and employer. This means that the same person makes both contributions.

There are two types of contributions made to 401(k) plans—elective deferrals and employer non-elective deferrals. Employees make elective deferrals and can include 100% of their compensation up to the limit of $19,500 per year.

If the employee is over 50, they can make catch-up contributions of an additional $6,500 per year (totaling $26,000 per year). The employer's contributions—called non-elective deferrals—can be a maximum of 25% of compensation after deductions calculated using tables and worksheets provided by the Internal Revenue Service.

Contribution limits are much higher for small business owners and their spouses, making the solo 401(k) an appealing retirement plan option over an IRA.

The result is that business owners can contribute a staggering total of $58,000 to their 401(k) plan annually. For business owners aged 50 or more, the total allowable annual investment is $64,500.

Once the plan is set up, business owners can make contributions for both themselves and their business. When they retire, they can make withdrawals and pay and necessary taxes.

A business owner and spouse could then contribute a hefty $116,000 (employer plus employee contributions for both of them) to their retirement savings, earning interest and keeping that money protected from income taxes for decades.

For instance, a husband and wife set up a limited liability company and launch a small business in their mid-20s. By the time they are 35 years old, they can pay themselves $175,000 per year before taxes.

They are the only employees of the holding company, so they can put $116,000 a year into their solo 401(k) plan. The couple initially places $116,000 into their 401(k). They could continue to put that amount in their plan but decide to reinvest it into their business, taking $75,000 per year for living expenses.

All 401(k)s are tax-deferred until distributions are taken, which allows for extra interest-earning power.

Over the next 25 years, they earned 8% annually on their money and continued to invest $24,000 per year ($2,000 per month). Their combined 401(k) accounts would have more than $2.5 million waiting to fund their retirement.

Tax Benefits of a Solo 401(k) Plan

If the couple continued to work as outlined in the example, all of that money would stay within the protected confines of the 401(k) account, earning dividends, interest, capital gains, and profits without having to pay any income taxes until they began withdrawing from the plan.

They would pay taxes in the 12% tax bracket and have enough retirement income to withdraw the same amount as they paid themselves while they were working. They would have plenty of money left over in their account—they could withdraw $75,000 per year for the rest of their lives and still have their plan earning more than $190,000 per year (tax-free) for them (($2.5 million - $75,000) x 8% per year).

Do I Need a 401(k) Solo Plan?

For sole proprietorship businesses, solo 401(k) plans are very effective ways to set aside and grow a large amount of money for retirement. If you're a small business owner and don't yet have a retirement plan set up, a solo 401(k) is an excellent way to save for retirement.

If you happen to need to hire employees at some time during your business's lifetime, you'll need to be sure to adjust the plan to include them equally or create criteria to define benefit-eligible employees and create retirement plans for them.

Key Takeaways

  • A solo 401(k) is a retirement plan for a small-business owner and their spouse.
  • The business owner acts as the employer and employee for contributions.
  • Contribution limits essentially double for a business owner and spouse.
  • Continuous investing is what allows the money to compound so quickly in a 401(k).