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Investor Insights Blog|Solo 401(k) Pros and Cons

Small Business Plans

Solo 401(k) Pros and Cons

If you’re a small business owner exploring your retirement saving options, you may find yourself coming across a Solo 401(k), also known as an Individual 401(k), as an option for you. If you’re eligible, a Solo 401(k) can be a powerful savings vehicle.

Regarding your retirement account as a small business owner, you are both the employee and the employer. With an Individual 401(k), there is an employee deferral, and then also an employer contribution.

A lot of people think of this like a match when you work for a company and they give you a 401(k) option, you make contributions, and they may match your contribution up to a certain amount.

As a business owner, you can have a Solo 401(k) (providing you meet all the requirements) and you can make an employee deferral just like you can with a company you work for as well as the employer contribution component.

So, what makes a Solo 401(k) so great? Here are some pros and cons for Solo 401(k)s.

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Solo 401(k) Pros

Higher Contribution Limits

With a Solo 401(k), if you are under the age of 50, as the employee, you can defer up to $19,500. Keep in mind, it’s up to 100 percent of your earned income, not to exceed $19,500.

If you’re over the age of 50, you have a “catch-up provision,” which basically means the older you get, the more you can defer to your retirement plan. This applies to IRAs as well as Solo 401(k)s. The contribution limit if you’re over 50 is $26,000 as the employee.

As the employer, you can contribute up to $37,500 of your income (if you maximize your employee deferrals), not to exceed 20 percent of your self-employment income, or 25 percent of your W-2 income.

In total, if you’re paying yourself enough, you could potentially get upwards of $57,000 if you’re under the age of 50 and up to $63,500 when you are over the age of 50.

If you are claiming a significant amount of earned income through a business, you can defer a significant amount of money into a plan such as a Solo 401(k) and your contributions are significantly higher than contributions to an IRA.

Tax Deductions

Contributions to a Solo 401(k) can be tax deductible. For example, if you maxed out and contributed the full $57,000, being under the age of 50, to your Solo 401(k) account, you could potentially receive a $57,000 tax deduction. With a Solo 401(k), you can elect to make tax-deductible deferrals, or you can elect to make tax-free Roth deferrals.

Possible Roth Component

With a Solo 401(k), you can defer a Roth component. With a Roth component, you make deferrals to the account with after-tax dollars. This means your funds grow in a tax-free environment and when you start taking distributions, you will have zero taxes to pay, providing all rules are followed.

There are no modified adjusted gross income (MAGI) limits with a Roth component. With a Roth component to a Solo 401(k), there are no income restrictions; you simply must have earned income in order to make the deferral.

Avoid UBIT

Another benefit of a Solo 401(k) is the possibility to avoid Unrelated Business Income Tax (UBIT) on leveraged real estate. If you buy real estate in an IRA and you take on a loan, you will likely pay unrelated business income tax on your net rental proceeds, or the net profits from the sale of the property while there’s leverage. And it’s based on a percentage of the property that is leveraged.

For example, if you buy a property for $100,000, and you get a loan for $50,000, you have 50 percent debt on the property in an IRA environment, therefore you would have to pay taxes on 50 percent of your net profits from that investment. Because you have that leverage in a Solo 401(k) environment, providing that the loan is structured properly, you are exempt from that UBIT.

UBIT could apply in other scenarios, including if your investment passes through a private entity such as an LLC. For more information on UBIT, please consult with your CPA or tax professional, and visit IRS.gov, Publication 598.

Spousal Solo 401(k)

If you have a spouse that is working for you and is employed by your business, meaning you are paying them a salary or a wage, if they are claiming that income, they can also take advantage of the Solo 401(k) as a participant of the plan.

Solo 401(k) Cons

No Employees

In order to qualify for a Solo 401(k), you cannot have any employees (other than your spouse), so if you have employees or want to have employees in the future, this plan is not for you.

5500 Filing

With a Solo 401(k), you are required by the IRS to file an annual report on Form 5500-SF if the account has $250,000 or more in assets at the end of the year. If you have less than $250,000, you may be exempt from the annual filing requirement.

Substantial and Recurring

The IRS requires contributions to a Solo 401(k) to be “recurring and substantial.” In general, this means you must make contributions somewhat regularly for the account to remain active.

According to the IRS, if the amount is not significant enough to show an intention to continue the plan, the IRS will treat the contributions as discontinued. Please check with an attorney or CPA for more information.

1

How long do transfers take?

The portion of the account transfer process that Equity Trust is responsible for takes approximately two to three business days. Once the transfer form has been mailed, the speed of process is up to the transferring custodian. The entire process can range from a few days to upwards of two months. Generally speaking, transfers take the following amount of time:

  • Cash Transfers- No matter where funds are being transferred from, cash transfers take the shortest period of time, approximately one to four business days.
  • Transfer from a Brokerage Account- The amount of time expected for a brokerage account transfer is approximately 10 to 15 business days from the date paperwork is completed. The actual time will vary depending on the speed with which the brokerage firm responds to our request.
  • Transfer from a Mutual Fund- The amount of time expected for a mutual fund transfer is approximately 14 to 21 days after the paperwork is received. The actual time will vary, depending on the speed with which the mutual fund responds to the transfer request.
2

Who is required to file for UBIT?

Anyone who has investments that are considered an unrelated business activity (like a LP or LLC) and/or contains debt financing within the tax-advantaged account and has gross income over $1,000.


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