image for A Step-by-Step Guide to Setting Up a Solo 401(k) for Self-Employed Professionals

Share this Post

Michael Reynolds sitting by a microphone and computer

Need help with your money or investments? Book a consultation to learn more about working together.

Book Online

A Step-by-Step Guide to Setting Up a Solo 401(k) for Self-Employed Professionals

Michael Reynolds | February 19, 2024

[Prefer to listen? You can find a podcast version of this article here: E213: A Step-by-Step Guide to Setting Up a Solo 401(k) for Self-Employed Professionals]

If you're a self-employed professional, setting up a Solo 401(k) can provide you with a powerful retirement savings tool. With a Solo 401(k), you have the opportunity to contribute both as an employer and as an employee, allowing you to maximize your retirement savings potential.

But where do you start? We'll take you through the step-by-step process of setting up a Solo 401(k) for self-employed professionals. Whether you're a freelancer, consultant, or small business owner, this guide will provide you with the information you need to establish a retirement plan that suits your needs and goals.

We'll dive into the benefits of a Solo 401(k), the eligibility requirements, the contribution limits, and the different investment options available to you. From choosing a custodian and filing the necessary paperwork, we'll walk you through each stage of the setup process.

What is a Solo 401(k) and who is eligible?

A Solo 401(k), also known as an Individual 401(k) or a self-employed 401(k), is a retirement savings plan designed for self-employed individuals or business owners with no employees, except for a spouse.

This retirement plan offers the same tax advantages and investment opportunities as a traditional 401(k) but with additional flexibility because the participant is also the business owner, which means you can take advantage of contribution limits on "both sides" of the contribution options.

To be eligible for a Solo 401(k), you must meet certain criteria. First, you must be self-employed or have self-employment income from a business that you own. This includes freelancers, consultants, sole proprietors, and small business owners. Second, you must not have any full-time employees, other than yourself and your spouse. Part-time employees who work less than 1,000 hours per year can be excluded from the plan.

Setting up a Solo 401(k) can be a great option for self-employed professionals as it allows for higher contribution limits compared to other retirement plans. It also provides the flexibility to contribute as both an employer and an employee, potentially allowing you to save more for retirement.

Additionally, a Solo 401(k) offers the same tax advantages as a traditional 401(k), such as tax-deferred growth and the potential for tax-deductible contributions. This means that the money you contribute to your Solo 401(k) grows tax-free until you withdraw it during retirement.

You can also have a Roth option which means you can save more into a Roth account than is typically allowed by a Roth IRA. And a Solo 401(k) is not subject to the income limits of a Roth IRA. You can make as much money as you want and you can still contribute to a Roth Solo 40(k).

Overall, a Solo 401(k) can be a powerful tool to help you save for retirement while maximizing tax benefits.

Advantages of a Solo 401(k)

A Solo 401(k) offers several advantages for self-employed professionals. It allows you to contribute both as an employer and an employee, providing you with the opportunity to maximize your retirement savings. As an employee, you can contribute up to employee 401(k) maximum contribution, while as an employer, you can contribute up to 25% of your net earnings from self-employment (or 25% of your salary if you're taxed as an S-corp). The employer contribution cannot exceed the total 401(k) limits for the given year.

Note that self-employment compensation is your “earned income,” which is defined by the IRS as net earnings from self-employment after deducting both:

  • one-half of your self-employment tax, and
  • contributions for yourself.

This dual contribution capability sets the Solo 401(k) apart from other retirement plans and allows for significant tax deductions and tax optimization.

Another advantage of a Solo 401(k) is its flexibility in terms of investment options. Unlike traditional 401(k) plans, which are often limited to a selection of mutual funds, a Solo 401(k) typically allows you to invest in a wide range of assets, including stocks, bonds, real estate, and even alternative investments like precious metals or cryptocurrencies. This flexibility gives you the ability to diversify and customize your portfolio. Not that the investment options will depend on the custodian where your investments are held.

Additionally, a Solo 401(k) can provide you with a powerful tool for minimizing your tax liability. Pre-tax (or "Traditional") contributions made to a Solo 401(k) are tax-deferred, meaning you don't pay taxes on that income until you withdraw it in retirement. This can result in significant tax savings, especially if you're in a higher tax bracket during your earning years.

Roth contributions don't receive a tax deduction up front but the money then grows tax-free and can be withdrawn tax-free in retirement once eligibility conditions are met.

Understanding contribution limits and deadlines

Before you dive into setting up your Solo 401(k), it's important to understand the contribution limits and deadlines associated with this retirement plan. As mentioned earlier, as an employee, you can contribute up to the current year employee max contribution for a 401(k).

Additionally, as an employer, you can contribute up to 25% of your net earnings from self-employment, or salary if you operate as an S-corp. However, the total contribution made by both the employee and the employer cannot exceed the annual limit set by the IRS, which varies from year to year.

It's important to note that contributions must be made by the tax filing deadline, including any extensions. For most self-employed individuals, this means contributing by April 15th of the following year. However, if you file for an extension, you have until October 15th to make your contributions for the previous tax year. It's crucial to adhere to these deadlines to ensure your contributions are valid.

If you operate as an S-corp, you need to get your employee contributions in before the end of the year so that your payroll properly reflects the contributions.

Step 1: Choosing a Solo 401(k) provider

The first step in setting up your Solo 401(k) is choosing a provider. A Solo 401(k) provider is typically a financial institution or a specialized retirement plan administrator that offers the necessary services to establish and manage your plan. When selecting a provider, there are several factors to consider.

There are two important components to a Solo 401(k) plan: the plan documents and the investment custodian.

The plan documents govern the plan, and the investment custodian holds the investments inside the plan. The two components can be bundled together or set up separately. Let's talk about plan documents first.

All 401(k) plans must be governed by valid plan documents.

Like their "regular" 401(k) counterparts, Solo 401(k) plans come with a set of governing documents that outline the specifics of how the plan operates. Think of these documents as the "blueprint" for the plan's design and administration.

However, because Solo 401(k)s cater to a different demographic, the documentation might be somewhat simpler, given there are fewer participants involved.

Here's what you'd typically find in Solo 401(k) plan documents:

  • Plan Adoption Agreement: This document is where the business owner establishes the plan and chooses its features, such as eligibility requirements, contribution types (pre-tax, Roth), and whether the plan will allow loans and rollovers. It's a customizable form that tailors the plan to the specific needs of the business and the owner.
  • Basic Plan Document: This is the comprehensive rulebook for the Solo 401(k), detailing the operational and administrative guidelines of the plan. It includes the legal language necessary for the plan to comply with IRS and Department of Labor (DOL) regulations, covering all aspects of plan operation, including contributions, distributions, and investments.
  • Summary Plan Description (SPD): Even though Solo 401(k)s are for a sole proprietor or a business owner and their spouse, an SPD is still provided. It summarizes the plan's key features in plain language, including how it works, who is eligible, how to make contributions, and how to take distributions. It's designed to ensure the plan participant understands their rights and obligations under the plan.
  • Trust Agreement: The assets of a Solo 401(k) must also be held in a trust, ensuring they are used exclusively for the benefit of the plan owner (and their spouse, if applicable). This document outlines the responsibilities of the trustee, who is typically the business owner, in managing the plan's assets.
  • Loan Documents (If Applicable): If the plan allows for loans, there will be documents that specify the terms and conditions under which plan loans can be made. This includes the maximum loan amount, repayment terms, and interest rates.
  • Funding Notice: While more common in traditional 401(k) plans with multiple participants, a funding notice may also be part of a Solo 401(k) package, explaining how the plan is funded and the investments available.
  • Annual Reporting (Form 5500-EZ): Once the plan assets exceed a certain threshold (usually $250,000), the Solo 401(k) plan administrator must file Form 5500-EZ annually with the IRS. This form reports on the plan's financial conditions, investments, and operations.

Solo 401(k) plan documents must be approved and filed with the IRS and have very specific requirements. So how do you get these plan documents?

This will depend on whether your Solo 401(k) is a "bundled" plan or if you are using a TPA, which is short for Third-Party Administrator.

Many investment custodians will offer what is called a "prototype" Solo 401(k) plan. This means that the custodian provides you with a set of basic documents that are IRS-approved and ready to use. Anyone opening a Solo 401(k) at the custodian uses the same basic plan documents. The prototype plan documents are also typically offered at no additional cost.

This can make the process very easy and convenient since you can set up everything in the same place. The downside can be that prototype plan documents provided by an investment custodian are typically very basic and do not allow certain features like loans and more customized options. However, they can work just fine for the majority of people setting up these plans.

You can also get plan documents from a TPA (Third-party Administrator).

In the context of Solo 401(k) plans, a TPA plays an important role, although its involvement might be less complex compared to traditional 401(k) plans due to the simpler structure of Solo 401(k)s. A TPA is an organization or individual expert in plan administration and compliance that manages various administrative responsibilities for retirement plans, including Solo 401(k)s.

For Solo 401(k) plans, the TPA's responsibilities can include:

  • Plan Documentation: Preparing and maintaining up-to-date plan documents, including the plan adoption agreement, basic plan document, and summary plan description. These documents are essential for establishing the plan's operational framework and ensuring compliance with IRS and Department of Labor regulations.
  • Compliance Testing: While Solo 401(k) plans are generally exempt from the nondiscrimination tests that apply to traditional 401(k) plans due to their single-participant nature, TPAs ensure compliance with other applicable rules and limits set by the IRS, such as contribution limits and reporting requirements.
  • Reporting and Filing: Assisting with the annual filing of IRS Form 5500-SF (Short Form) or Form 5500-EZ if the plan's assets exceed a certain threshold. This includes preparing the forms and ensuring they are filed timely to avoid penalties.
  • Contribution Calculations: Helping determine the maximum allowable contributions, including employee deferrals and employer contributions, based on the self-employed individual's income and the IRS limits.
  • Distributions and Loans: If the plan allows for loans or when it's time for distributions, the TPA can provide guidance on the rules and prepare the necessary documentation to ensure these transactions comply with the plan provisions and IRS regulations.
  • Advisory Services: Offering advice on plan design options and changes in legislation that may affect the plan. TPAs can help tailor the Solo 401(k) to the business owner's specific needs, providing flexibility and maximizing retirement savings.

If you use a TPA, you can generally set up the actual investment accounts at any custodian that offers the correct account types for a Solo 401(k). This would be an "unbundled" solution because you are getting the plan documents from the TPA and setting up the investment accounts at the custodian of your choice. The two components are independent of each other, although they do work together.

A TPA does charge a fee for setup and ongoing administration so be aware that this will mean additional costs.

Given the relatively straightforward nature of Solo 401(k) plans, some business owners may opt to handle the administrative responsibilities themselves, especially if they're comfortable with the requirements and seeking to minimize costs.

Bottom line: if your needs are simple and you don't yet have a lot invested in your Solo 401(k), a bundled solution with a prototype plan might meet your needs just fine. If your needs are more complex, you may want to opt to use a TPA.

As a side note, working with a financial advisor can be a great way to make sure you are setting up the Solo 401(k) properly and that you are staying compliant.

Step 2: Setting up your Solo 401(k) account

Once you've chosen a Solo 401(k) provider (whether bundled or un-bundled), the next step is to set up your account. This involves completing the necessary paperwork and providing the required documentation to establish your plan. The specific requirements may vary depending on the provider you choose, but generally, you'll need to provide information about yourself, your business, and your financial situation.

To start, you'll typically need to fill out an application form provided by the Solo 401(k) provider. This form will ask for basic personal information such as your name, address, social security number, and contact details. You'll also need to provide information about your business, including its legal name, type of business entity, and employer identification number (EIN) if applicable.

In addition to the application form, you'll need to provide the plan documents discussed previously. If you're using a custodian that bundles prototype plan documents with the account, you will likely sign the plan documents during the process of opening the accounts.

If you are using plan documents provided by a TPA, you will need to provide the plan documents to the custodian before the accounts can be set up.

If your plan documents and your custodian supports it, you will generally set up two accounts: a Traditional Solo 401(k) and a Roth Solo 401(k). This is to separate the two types of contributions and to document what is pre-tax money and what is Roth money. The accounts are governed by the same plan documents and are part of the same Solo 401(k) plan, but are distinct accounts for record-keeping purposes.

Sometimes a third account may be set up for after-tax contributions but that is for more customized situations such as mega backdoor Roth contributions.

Step 3: Determining your contribution amount

Once your Solo 401(k) account is set up, it's time to determine how much you can contribute. As mentioned earlier, the contribution limits for a Solo 401(k) consist of both employee contributions and employer contributions.

The employee contribution is set each year by the IRS so you'll want to look up the 401(k) contributions limits for the current year. This limit applies to each individual participant, regardless of whether they have multiple businesses or sources of self-employment income.

In addition to the employee contributions, you can also make employer contributions to your Solo 401(k). The employer contribution is calculated as a percentage of your net earnings from self-employment (or salary if you operate as an S-corp), up to 25%. It's important to note that the total contribution made by both the employee and the employer cannot exceed the annual limit set by the IRS.

To determine your contribution amount, you'll need to calculate your net earnings from self-employment. This is typically done by subtracting your business expenses from your total self-employment income. Your compensation used to calculate your allowed contribution is your “earned income,” which is defined as net earnings from self-employment after deducting both:

  • one-half of your self-employment tax, and
  • contributions for yourself.

Once you have your earned income, you can calculate your maximum employer contribution by multiplying it by 25%, or 1/4. Remember to consider any other retirement plans you may have, as the contribution limits may be affected by your participation in multiple plans.

If you are an S-corp, you will take 25% of your W-2 wages to get the employer contribution limit.

Step 4: Making contributions to your Solo 401(k)

After determining your contribution amount, it's time to start making contributions to your Solo 401(k) account. The frequency and method of contributions may vary depending on your chosen provider, but generally, you'll have the option to make contributions on a regular schedule or as a lump sum.

If you choose to make regular contributions, you can set up automatic transfers from your business bank account to your Solo 401(k) account. This ensures that your contributions are made consistently and helps you stay on track with your retirement savings goals.

Alternatively, if you prefer to make lump sum contributions, you can do so at any time as long as you meet the contribution deadlines mentioned earlier. Lump sum contributions can be advantageous if you have irregular income or if you want to get as much money invested as early as possible.

Regardless of the contribution method you choose, it's important to keep track of your contributions and maintain accurate records. This will not only help you stay organized but also make it easier to report your contributions on your tax returns.

Remember that if your business is an S-corp, you'll need to report the contributions on your payroll so that your W-2 properly reflects your contributions.

Step 5: Managing investments within your Solo 401(k)

One of the key advantages of a Solo 401(k) is the ability to invest in a wide range of assets. Once your contributions are made, it's time to start managing your investments within your Solo 401(k) account. The specific investment options available to you may vary depending on your chosen provider, but generally, you'll have the flexibility to invest in stocks, bonds, mutual funds, real estate, and more.

Before making investment decisions, it's important to consider your risk tolerance, investment goals, and time horizon. Diversification is also a crucial aspect of investment management, as it helps spread the risk across different asset classes and reduces the impact of market volatility on your portfolio.

To manage your investments effectively, it's recommended to review your portfolio regularly and make adjustments as needed. This may involve rebalancing your portfolio to maintain your desired asset allocation, taking into account changes in market conditions or your personal circumstances.

Once again, if you don't feel comfortable managing your own investments, working with a financial advisor can help.

Step 6: Taking distributions from your Solo 401(k)

While the primary purpose of a Solo 401(k) is to save for retirement, there may come a time when you need to take distributions from your account. Distributions from a Solo 401(k) are generally subject to income tax if they are pre-tax contributions and may be subject to early withdrawal penalties if taken before the age of 59 1⁄2.

Roth money can be withdrawn tax-free if eligible, typically after age 59 1⁄2.

The specific rules and regulations regarding distributions from a Solo 401(k) can be complex, and it's recommended to consult with a tax professional or financial advisor before making any decisions. They can help you understand the tax implications and guide you through the process of taking distributions in a tax-efficient manner.

Conclusion: The Benefits of a Solo 401(k) for Self-Employed Professionals

Setting up a Solo 401(k) can be a smart move for self-employed professionals looking to maximize their retirement savings. With the ability to contribute both as an employer and an employee, a Solo 401(k) offers flexibility, tax advantages, and a wide range of investment options.

It's one of the best retirement plans available to business owners and can give you lots of flexibility when it comes to managing taxes and saving for retirement.