The Individual 401(k) — a.k.a. Solo 401(k) or Self-Employed 401(k)

(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

One of the biggest benefits of being self-employed is that there are more (and better) retirement plan options available to you than are available to most taxpayers. Rather than discussing every single option available, I want to focus on the one that makes sense for most sole proprietors: the individual 401(k), which is also known as a solo 401(k) or self-employed 401(k).

But before we dive into discussing the individual 401(k), I want to provide just a few notes about some circumstances in which you might want to consider other types of retirement plans:

• If you have very high income from your business (at least a few hundred thousand dollars per year), you may want to consult with a tax professional about a defined benefit plan.
• If you have employees, definitely consult with a tax professional, not only because there are additional factors in the decision of which plan to open, but because there are ongoing reporting and nondiscrimination requirements as well.
• If you have a “day job” with a 401(k) or 403(b) to which you are already making the maximum contribution—and you intend to keep making the maximum contribution to that plan—a SEP IRA may offer the same contribution limit as an individual 401(k), with less paperwork.
• There’s usually no benefit to opening more than one retirement plan for your business, because the contribution limits are generally not cumulative.

Contribution Limits

An individual 401(k) plan functions much like a 401(k) or 403(b) plan with a person’s employer. The primary difference is that you are allowed to make a contribution in the role of employee and a contribution in the role of employer. Specifically, you are allowed to make:

1. An employee contribution of $23,000 for 2024,
2. An employer contribution equal to 20% of your net earnings from self-employment, and
3. A catch-up contribution of $7,500 for 2024 if you’re age 50 or older. (Beginning in 2025, people age 60-63 as of the end of the year will be able to make catch-up contributions up to 150% of the regular catch-up contribution limit.)

In this case, your net earnings from self-employment is defined as your business’s profit, minus the deduction for one half of your self-employment tax.

However, there are a few additional limitations to the above contributions. Specifically:

• The employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution,
• The employee and employer contributions are limited to a combined total of (for 2024) $69,000, and
• The total contribution is limited to your net earnings from self-employment.

Also, as we’ll discuss shortly, if you have another job (i.e., a “day job”), your maximum employee contribution and catch-up contribution will be affected if you make contributions to a retirement plan at that other job.

EXAMPLE: You’re under 50 years old, and you have a business with no employees. Your net earnings from self-employment are $100,000 for 2024. If you have an individual 401(k) plan (and no other retirement plans to which you’re contributing), your contribution limit will be $43,000 calculated as follows:

• Employee contribution of $23,000, plus
• Employer contribution of $20,000 (20% of $100,000).

Tax-Deferred or Roth

As of 2024, the tax code allows all three types of individual 401(k) contributions (i.e., the employee contribution, the employer contribution, and the catch-up contribution for people age 50 and over) to be either tax-deferred or Roth.

Tax-deferred contributions function similarly to a traditional IRA. That is:

• Contributions made to the plan reduce your taxable income,
• You do not have to pay tax on any growth as long as the money stays in the plan, and
• When you take the money out of the account, it will be taxable as income (and potentially subject to a 10% penalty if you’re younger than 59.5).

One important point is that contributions are adjustments to income rather than Schedule C deductions, meaning they save you money on income tax but not self-employment tax.

If you choose to make Roth contributions rather than tax-deferred contributions, you do not get any tax savings immediately (i.e., no deduction). However, when you ultimately take distributions from the plan they will be entirely tax-free, if you are at least age 59.5 and it has been at least 5 years since the first day of the calendar year in which you first made a Roth contribution to the plan.

Note, however, that while the law allows for Roth contributions, the individual 401(k) plans offered by many brokerage firms do not allow for Roth contributions. So if you want to make Roth contributions, be sure to check with the brokerage firm(s) that you’re considering, to make sure that they allow for such.

Another important point here is that Roth employer contributions and Roth catch-up contributions are both new, as a result of the SECURE Act 2.0 (passed in December 2022). So there are some financial institutions that do allow for Roth employee contributions but aren’t yet set up for Roth employer contributions or Roth catch-up contributions.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

Paperwork

One disadvantage of an individual 401(k) relative to, for example, a SEP IRA or SIMPLE IRA is that they require more paperwork to set up. (With some brokerage firms, it’s actual physical paperwork that must be mailed, rather than online forms.) In addition, individual 401(k) plans require you to file Form 5500-EZ with the IRS every year once the plan reaches $250,000 in assets.

Beginning in 2026, catch-up contributions will be required to be Roth, rather than tax-deferred, for employees whose wages in the prior year from the employer offering the plan exceeded $145,000. Based on the wording of the law, it sounds like this might not apply to sole proprietors (because sole proprietors are not employees with wages). But as of this writing the IRS has not yet provided any guidance on that topic.

Relevant Deadlines

An individual 401(k) can be set up as late as the due date for the business’s tax return for the year. The deadline for contributions is the same date. For a sole proprietor, this means that you can set up the plan and make contributions for a given year as late as April 15 of the following year.

What if You Have Other Retirement Accounts?

Opening and contributing to an individual 401(k) will not affect your ability to contribute to a traditional or Roth IRA. It could, however, affect your ability to claim a deduction for a contribution to a traditional IRA, because if you have an individual 401(k), you are considered to be covered by a retirement plan at work, which means that if your adjusted gross income is over a certain amount, you will not be able to claim a deduction for a traditional IRA contribution.

In addition, if you have another job as an employee and you are allowed to contribute to a 401(k) or 403(b) at that job, contributions you make to your plan at work—to take advantage of an employer matching contribution for instance—will count against the limit for employee contributions to an individual 401(k). And the same goes for catch-up contributions. That is, catch-up contributions made to your plan at work will count against the catch-up contribution limit for your individual 401(k). And it works in the other direction too—employee and catch-up contributions you make to an individual 401(k) will count against the contribution limits for your plan at work.

EXAMPLE: Jan is 40 years old and has a full-time job that offers a dollar-for-dollar match for contributions she makes to her 401(k), up to $4,000. She also has a part-time business for which she has an individual 401(k). Her net earnings from self-employment are $40,000.

To get the maximum match from her employer, she contributes $4,000 to her 401(k) at work. The maximum employee contribution she can make to her individual 401(k) for the year is $19,000 ($23,000 — $4,000). In addition, she can make an employer contribution of up to $8,000 (20% of her net earnings from self-employment).

Simple Summary

• An individual 401(k) is an excellent retirement account for most sole proprietors. In most cases, an individual 401(k) will allow for greater contributions than other types of self-employed retirement accounts such as a SEP IRA or SIMPLE IRA.
• Contributions to an individual 401(k) can be tax-deferred (thereby offering immediate tax savings) or Roth (thereby offering eventual tax-free distributions). Note, however, that some brokerage firms only allow for tax-deferred contributions.
• If your individual 401(k) reaches $250,000 of assets, you’ll have to file Form 5500-EZ each year.