The Solo 401(k) is a perfect tool for small business owners looking to maximize their retirement contributions. Any type of business can qualify. This means corporations, LLCs, partnerships and sole proprietors are all eligible. The only requirement is that you have no employees, other than a spouse, who work more than 1,000 hours per year.
Contributions come from two sources. The first is from the employee, which in this case would be the business owner. For 2018, the business owner can contribute 100% of his first $18,500 in wages. The second source is from the business itself. If the business is a corporation, it can make a contribution of up to 25% of the business owner's wages. If it is not a corporation, it can make a contribution of up to 20% of the net business income. These contributions are tax-deductible and are immediately 100% vested. Furthermore, the contributions and their earnings grow tax-deferred.
The generous contribution limits are one of the appeals of a Solo 401(k). Comparing it to another popular retirement vehicle for self-employed individuals — the SEP IRA — one can easily see the difference. Take, for example, a contractor with an S-Corporation who makes $80,000 per year. With the SEP IRA he could contribute 25%, or $20,000, each year. However, with the Solo 401 k he could contribute $16,500 plus 25% of $80,000 for a total of $36,500.
An added benefit is the ability to borrow against the savings in the account. Up to 50% of the account's balance can be taken as a tax-free loan. Repayment terms for the loan can vary, but typically, it must be completed within five years. A maximum of $50,000 can be loaned.
Small business owners should be aware of some limitations. The maximum contribution for any calendar year is $55,000, or $61,000 if the owner is 50 or older. Withdrawals before the age of 59 1/2 will incur a 10% penalty. Distributions must start by the age of 70 1/2. In general, reporting requirements and administrative fees will be higher than with other small business retirement options.
A plan can be opened at any time during the year and contributions made will be tax-deductible for that year. Initial funding of a new plan can come from contributions, rollovers from other retirement plans, or a combination of the two.