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Retirement

Solo 401k Benefits & Tax Advantages: Is a Solo 401k Worth It?

Solo 401k benefits:

  1. High contribution limits: $61,000 for 2022 ($67,500 if you're over 50).
  2. Tax deductions on contributions: Reduce your taxable income by deducting up to $61,000 ($67,500 if over 50).
  3. Roth option: Contribute up to $20,500 ($27,000 if over 50) to a Roth account and pay zero taxes on withdrawals.
  4. Tax-free compounding: Zero taxes when you sell assets. Your money compounds tax-free.
  5. Investment freedom: Invest in any asset class you want.
  6. Loan option: Take out a loan up to $50,000 with no credit checks and no restrictions on how you use the money.
  7. Add your spouse: Double your household contribution limits for the year by adding your spouse.
  8. No annual tax filings: You're only required to file taxes on your account if your assets exceed $250,000 in value.
  9. All business entities eligible: Business owners with any business structure can open a solo 401k.
  10. Unlimited rollovers: There's no limit on how much you can rollover from another retirement account. All retirement accounts, except a Roth IRA, can rollover funds and/or assets to a solo 401k.

Considering a solo 401k?

Here's a quick breakdown of every benefit and tax advantage a solo 401k account can give you.

High contribution limits

The solo 401k has one of the highest contribution limits of any retirement plan. In fact, it's almost 3x higher than a traditional 401k and over 10x higher than a Roth IRA.

For 2022, the solo 401k contribution limit is $61,000. If you'll be at least 50 years of age by the end of the year, you can contribute an additional $6,500 in catch-up contributions, bringing your total limit to $67,500.

Comparably, a company 401k has a contribution limit of $20,500 ($27,000 if you're over 50) and a Roth IRA has a limit of just $6,000 ($7,000 if you're over 50).

The reason why it's so high is because with a solo 401k, you contribute as BOTH the employer and the employee.

Tip: If you're using the Mega Backdoor Roth strategy with a solo 401k, you could contribute up to $61,000 into a Roth IRA or a Roth solo 401k.

Tax deductions on contributions

You can contribute up to the maximum amount of $61,000 ($67,500 if over 50) with pre-tax income.

Put another way, you can subtract up to $61,000 ($67,500 if over 50) from your taxable income for the year - a huge tax deduction that may even bring you down a full tax bracket.

Roth option

With a solo 401k, you also get a Roth option.

Instead of contributing with pre-tax income, you can choose to contribute with after-tax income into a Roth solo 401k account.

While you'll have to pay taxes now and won't get a tax deduction for the year, your withdrawals in retirement will be completely tax-free.

The Roth solo 401k option is only available on employee contributions.

You can read the full details about that here, but here's a quick breakdown of how it works:

With a solo 401k, you contribute as both the employer and the employee. In other words, the $61,000 contribution limit is broken up into two parts: the employee side and the employer side.

On employee contributions, you're allowed to contribute up to 100% of your income, up to a maximum of $20,500. The remaining can be covered with employer contributions.

EMPLOYEES have the option to contribute to a regular solo 401k (with pre-tax income) OR to a Roth solo 401k (with after-tax income). It's completely up to you.

The benefit of the Roth solo 401k is that your nest egg can be withdrawn in retirement without having to pay any taxes on it. On the other hand, contributions made with pre-tax income will get taxed as income when you withdraw.

It works similarly to a Roth IRA, except you have a much larger contribution limit.

  • Roth IRA contribution limit: $6,000 ($7,000 if over 50).
  • Roth solo 401k contribution limit: $20,500 ($27,000 if over 50).

Again, only employee contributions have the Roth option. Contributions made as an employer must be with pre-tax income.

Tax-free compounding

When you sell assets in a solo 401k account, you pay zero taxes on the gains. Your money compounds tax-free (for both pre-tax contributions and after-tax contributions).

Tax-free compounding can significantly grow your account over the years, especially if you start contributing at an early age.

And with the Roth option, you pay zero taxes on it no matter how much it grows. Whether your account grows 5x or 50,000x, it's all yours.

When are you allowed to withdraw?

You can withdraw from your solo 401k when you turn 59½ years old. Early withdrawals pay a 10% fee + income tax. You can learn more about withdrawal rules here.

Freedom to invest in what you want

The solo 401k is self-directed. Unlike a traditional 401k account, where your options are limited to whatever stocks and funds your company provides, a solo 401k is self-directed. You get the freedom to choose what you want to invest in.

Along with stocks, ETFs, and mutual funds, you can use your solo 401k to invest in things like real estate, mortgage notes, precious metals, and even crypto.

If you're accredited, you can even write small checks into a friend's startup or fund through your account.

And the cool part is, if you invested through your Roth solo 401k account, you'd pay no taxes when you take the money - even if your friend's startup becomes the next Google and you turn your "small check" into billions.

Loan option

Some solo 401k plans offer a loan option. While it's typically not the best idea, it's still a nice option to have.

Solo 401k loans are easier to access and gets processed a lot faster than traditional loans with other financial institutions. There are no credit checks, and no restrictions on how you use your money.

You're allowed to borrow up to 50% of your account balance up to a maximum of $50,000. The remaining 50% of your account would act as the collateral in case you can't pay it back.

Interest rates on the loan are usually Prime Rate plus another one or two percent. While it beats paying early withdrawal fees, solo 401k loans should only be considered as a last resort.

You're borrowing your money and paying the government the interest. And whatever you take out as a loan is money that can't be invested with tax-free compounding in your solo 401k.

Ability to add a spouse

To be eligible for a solo 401k, you're not allowed to have any full-time employees that work more than 1,000 hours per year in your business. The only exception is your spouse.

If your spouse works in your business, they can be added to your solo 401k and they would get their own contribution limits. In other words, you both get to contribute up to the maximum amount of $61,000 ($67,500 if you're both over 50). Combined, that's a household total of $122,000 ($135,000 if you're both over 50).

No annual tax filings

A solo 401k is a little more complicating to set up than a SEP IRA or Roth IRA, but it's much easier to manage. There is no annual tax filing for any account that has less than $250,000 in assets.

If you do have $250,000 or more in your account, you'll have to file a Form 5500-EZ each year.

All business entities eligible

Any business owner with no employees (other than your spouse) can open a solo 401k account, regardless of what business structure they have.

Whether you have a sole proprietorship, partnership, LLC, S corp or C corp, all entities are eligible.

Unlimited rollovers from other accounts

When you open a solo 401k, you have the option to rollover funds and/or assets from any other retirement account that already have (except from a Roth IRA).

And there's no limit on how much you can rollover.

Because rollovers are treated different than contributions, you're allowed to rollover as much as you want, and still be able to contribute up to the maximum amount allowed for the year.

Not all solo 401k plans offer every benefit

For most business owners, a solo 401k is like getting free money from the government and should look into setting one up asap. The benefits and tax advantages far outmatch any other retirement account.

But before you do, keep in mind that every solo 401k plan comes packaged differently.

Many solo 401k plans don't come with a Roth option, which is arguably the most important benefit of all.

Some offer a Roth option, but don't allow rollovers, which leaves you stuck with the majority of your retirement savings in an inferior plan.

Some offer rollovers, but don't allow full investment control, which means you can't do cool things like buy bitcoin or invest in your friend's hot new startup.

If you're eligible for a solo 401k, it's important to vet your options carefully and choose a plan that is able to offer the full benefits that you're looking for in a solo 401k.

The Ocho Solo 401k is a full-suite plan for business owners and entrepreneurs, with fully-managed account setup, tax filings, curated investments, compliance monitoring, and no AUM fees. Learn more about it here.

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