Solo 401(k) plans allow corporations, partnerships, and sole proprietorships with no employees (aside from you, your spouse, and/or business partner) to make contributions toward retirement. Self-directed solo 401(k) plans give small business owners the freedom and control to choose their own assets and use alternative investments to build retirement wealth. This article explains the benefits of solo 401(k) plans you may not know.
What Is a Self-Directed Solo 401(k)?
A solo 401(k) plan is a profit-sharing plan with a 401(k) option. This plan has more relaxed compliance rules and minimal costs compared to a traditional 401(k). Standard solo 401(k) plans can be established at banks or other mainstream IRA providers, but plan owners are restricted to investments offered by those providers.
A self-directed solo 401(k) allows plan owners to invest outside the limited realm of stocks, bonds, and mutual funds. Instead plan owners can use real estate, private equity, Bitcoin and other cryptocurrency, private lending, and a large number of other alternative assets, to grow tax-advantaged income in the plan. You can invest in things you know and understand to grow wealth for retirement.
Key Features of Solo 401(k)s:
- Business owners are also considered employees and can make both employee and employer contributions to a solo 401(k).
- Annual contribution limits are higher than traditional and Roth IRAs.
- Roth and mega Roth components allow after-tax contributions and tax-free distributions on Roth component earnings in the account when you retire.
7 Benefits of Solo 401(k) Plans
The following benefits apply to typical and self-directed solo 401(k) plans.
1. Your annual contribution limits are higher (max them out).
Higher contributions are one of the main attractions of these plans.
As an employee for the year 2022, a salary deferral of up to $20,500 can be made to a solo 401(k). An extra $6,500 catch-up contribution is allowed for those over 50 years of age.
In addition to the employee salary deferral, the profit-sharing employer portion allows deductible contributions of up to 25 percent of compensation, with total contributions (salary deferral plus profit-sharing match) not exceeding $61,000 per person for 2022 or $67,500 if you’re over 50.
In 2023, those contribution thresholds are higher, with the total at $66,000 for those under 50 years old. The combined total with the catchup contribution for those 50 and older is $73,500.
Additionally, in 2023 and later years, employers have the option to make their matching contributions to employees’ plans in Roth dollars. This was not an option before the SECURE Act 2.0 passed in late 2022.
2. There are two Roth components available for solo 401(k) plans.
There are two Roth components you can utilize in your solo 401(k) that can significantly maximize your retirement savings and wealth-building potential.
Roth 401(k) component:
Often called a Roth 401(k), this component allows employees to make post-tax contributions to the solo 401(k). The earnings of these Roth contributions grow tax free, making your distributions in retirement tax-free.
- No income limits for Roth contributions like there are for a typical Roth IRA.
- Employee Roth contributions in 2022 can be up to $20,500 (or up to $27,000 if you are 50 or older).
- Section 604 of the SECURE Act states that beginning in 2023 employers have the option to designate their matches and nonelective contributions as Roth contributions.
- If employers opt out of making Roth contributions, their pre-tax contributions can be converted to the Roth component by the employee.
- Distributions of earnings from the Roth component are tax free if you are 59 ½ years or older and have owned the Roth 401(k) for 5 years.
Mega Roth 401(k) component:
The mega Roth strategy works in conjunction with the Roth component. The benefit this provides comes into play when the combined employee and employer contributions don’t reach the annual limit. In that case, you can make an employee after-tax, non-Roth (mega Roth) contribution of the difference and immediately perform an in-plan Roth conversion to capture tax-free growth on those funds.
Requirements for mega Roth strategy:
- Your solo 401(k) must allow in-plan Roth conversions.
- The Roth IRA component must allow mega Roth contributions.
- If an immediate in-plan Roth conversion of your mega-Roth contribution is not performed, the income gained on those contributions grows tax deferred instead of tax free.
3. You can give yourself a non-taxable loan from your solo 401(k).
The loan from your solo 401(k) is not taxable as long as you repay it, along with a realistic interest rate, within five years. You can borrow up to 50 percent of the vested assets in the plan or up to $50,000, whichever is less. If you don’t repay within the terms, the remaining balance will be taxed and penalized as an early distribution.
4. You can take a hardship distribution from your plan.
This is a bit different than a loan, and the IRS has terms and hardship qualifications that you must meet to take a hardship distribution. Consult with a tax professional before making this move to ensure you qualify and take the distribution within IRS compliance.
5. You can make contributions in cash or property.
Whether your contribution is cash or property, the value must not exceed the annual contribution limits for your plan.
6. C corporations can take deductions on contributions.
C Corps can make contributions in the form of cash, property, or corporate stock. There are IRS rules to this benefit, but it can have a positive impact on your income tax liability, so it’s worth checking in to.
7. Trustees have checkbook control, making it easier to invest.
Trustees of these accounts can be the business owner(s) and/or spouse(s). Either way, you have checkbook control of the funds in your plan, which means you can write checks from the account to make an investment.
Your Takeaway on a Self-Directed Solo 401(k) Plans for Small Businesses
Those are just a few tips business owners should know about solo 401(k) plans. Your CPA or other tax professional can help you navigate the benefits and nuances of this plan to ensure you reap the benefits and also comply with IRS regulations.
Small business owners should consider self-directed solo 401(k) plans if:
- You are a sole proprietor with no employees other than your spouse or partner(s).
- You are looking for the largest potential contribution for a business without employees.
- You want the capability of borrowing from your plan.
- You want the ability to invest in alternative assets.
- You want to purchase leveraged real estate in your plan and wish to avoid UBIT (unrelated business income tax).
It is a good idea to discuss the pros and cons with your financial advisor or tax professional. The benefits of solo 401(k) plans for small business owners are tremendous if your business falls within the requirements but owning and operating any retirement plan outside the realm of IRS rules can have disastrous results.
If you would like to know more about how self-directed solo 401(k) plans work, please contact Advanta IRA today.
Additional reading on solo 401(k) plans and how to invest in alternative assets:
This article first published on September 8, 2022, and has been updated with provisions from the SECURE Act 2.0 and other current information.