What is a self-employed 401(k) plan?

Most workers are at the whim of their employer when it comes to retirement accounts. But when you're self-employed, you have control. You can choose which retirement accounts are right for your goals — and how to best utilize them.

There are several accounts you can choose from, including a solo 401(k). These are similar to a 401(k) you might get at a salaried position, though they actually allow you to save significantly more annually.

You can explore your retirement options, including IRAs, by reviewing top providers online now. 

What is a self-employed 401(k) plan?

Are you self-employed? Here's what you need to know about solo 401(k)s and how to open one.

A self-employed 401(k) plan — also called a one-participant 401(k), individual 401(k) or solo 401(k) — is a type of retirement account for business owners with no other employees. They're designed only for use by a self-employed professional and, if applicable, their spouse.

With a solo 401(k), a self-employed person is considered both an employer and an employee. This means they can make contributions to the account as both parties. 

Currently, the IRS limits annual self-employed 401(k) contributions:

• For the employee: Up to $20,500 (if you're under 50) or $27,000 (if 50 or older)
• For the employer: Up to 25% of the employee's total compensation. This is your net earnings minus half your self-employment tax and the contributions you put into your 401(k) as an employee.
• Total between both parties: $61,000 ($67,500 for 50 or older) 

Keep in mind that the IRS reevaluates its contribution limits annually, so these thresholds might change.

Alternative options

The two most common alternatives to a solo 401(k) are SEP-IRAs and SIMPLE IRAs. 

• SEP IRA (Simplified Employee Pension): This lets you contribute up to $61,000 for 2022. All contributions are tax-deductible, and your account balance grows tax-free until you retire. You'll only pay taxes when you withdraw money down the line.
• SIMPLE IRAs (Savings Incentive Match Plans for Employees): These have much lower contribution limits. They allow you to save up to $14,000 of your net earnings ($17,000 if you're 50 or older), plus a 2% fixed contribution or 3% matching contribution as the "employer." 

You can easily review your IRA options online now.

Pros and cons of self-employed 401(k)s

There are many benefits to solo 401(k)s. 

• High contribution limit: They have a high contribution limit, which allows you to build up retirement savings fairly quickly. 
• Tax-deductible: They're tax-deductible and are funded using pre-tax earnings, meaning you won't need to pay taxes on the money until withdrawing it later on. This can be beneficial if you expect to be in a lower tax bracket come retirement.

However, there are also some downsides:

• Age limit: You have to be at least 59 ½ to start withdrawing money, or you may face a 10% early withdrawal penalty. 
• It doesn't cover your employees: You also can't use a self-employed 401(k) to cover employees, so if you think you might expand your business in the future, it might not be the best choice.

How to set up your self-employed 401(k) plan

To set up an individual 401(k) plan, you'll first need to have an Employer Identification Number. You can get one of these by applying online through the IRS.

Once you have an EIN, you just choose your brokerage, fill out their required application form and fund your account. You can then choose investments and start building up your retirement savings.

If you're not sure if this self-employed retirement plan is best for you, talk to a financial adviser or tax preparer. They can help you pick the best account for your goals and business.