8 Things to Know About Individual 401ks

Ezra Summers

June 28, 2023

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Picture a 401k as your trusty retirement savings vehicle. This contraption, named after its location in the tax code, lets you put a part of your paycheck into a special account before Uncle Sam takes his share in taxes. In other words, it’s a sweet little tax-deferred nest egg.

As we sail towards our golden years, it’s essential to understand the options we have for our retirement savings. Let’s coast into the world of 401ks and cover some ground on everything you need to know about individual 401ks.

401k Plans: A Quick Overview

A 401k is a type of retirement savings plan that, traditionally, employers provide to their employees in the United States. It allows you to contribute a portion of your salary to the plan on a pre-tax basis, meaning the contributions are deducted from your paycheck before income taxes are applied. The money in a 401k account grows tax-deferred, which means you only pay taxes on the earnings or investment gains once you withdraw the funds.

Many employers offer 401k plans as part of their benefits package. Some employers even match a portion of your contribution—essentially free money. It’s a valuable benefit that can help boost your retirement savings.

One of the key advantages of a 401k is the potential for long-term growth. The funds in the account can be invested in various options such as mutual funds, stocks, bonds, or target-date funds, allowing your savings to grow over time.

It’s important to note that 401k plans are subject to specific rules and regulations. The Internal Revenue Service (IRS) adjusts retirement plan contribution limits annually for inflation.

As of 2023, the limit for:

Your contribution is $22,500 annually.
Your contribution, if you’re 50 or older, is an extra $7,500 as a “catch-up” contribution.
The general limit on total employer and employee contributions for 2023 is $66,000 ($73,500 with catch-up).

Additionally, there may be restrictions on when and how you can withdraw funds without penalties, typically before the age of 59½. Removing funds before reaching retirement age may be subject to income taxes and early withdrawal penalties.

Meet the Individual & Solo 401ks

The terms “individual 401k” and “solo 401k” are often used interchangeably and can refer to the same type of retirement savings plan. They are for self-employed individuals or business owners with no full-time employees other than themselves and their spouses.

The solo 401k is like the wild cousin of the traditional 401k. Here are some key features and benefits of individual/solo 401k plans:

Higher contribution limits: Individual/solo 401k plans typically have higher contribution limits than other retirement plans for self-employed individuals, such as SEP or SIMPLE IRAs.
Employer and employee contributions: As both the employer and the employee, self-employed individuals can contribute to their individual/solo 401k. Contributions can be made on a pre-tax basis, reducing current taxable income, and the earnings grow tax-deferred until withdrawal.
Flexibility in contributions: Individual/solo 401k plans allow for both salary deferral contributions (employee contributions) and profit-sharing contributions (employer contributions). Your income and contribution percentages determine the maximum contribution, and the contributions are generally tax-deductible.
Investment options: Individual/solo 401k plans offer a wide range of investment options, including stocks, bonds, mutual funds, and other investment vehicles, depending on the provider or custodian of the plan.
No nondiscrimination testing: Since the individual/solo 401k is limited to the business owner and their spouse as the only eligible participants, there is no requirement to perform nondiscrimination testing, which can be required for traditional 401k plans with regular employees.

It’s worth noting that the specific rules and regulations for individual/solo 401k plans may vary depending on the plan provider and the account’s custodian.

Types of 401ks

Type of 401k Plan	Description
Traditional 401k	The most common type of 401k plan offered by employers. Contributions are made on a pre-tax basis, reducing your taxable income for the year. The earnings on your investments grow tax-deferred until withdrawal, at which point they are subject to ordinary income tax.
Roth 401k	Similar to a traditional 401k, but contributions are made on an after-tax basis. This means you don’t get an immediate tax deduction, but qualified withdrawals in retirement are tax-free, including the earnings on your investments.
Safe Harbor 401k	Designed to help employers meet certain nondiscrimination requirements set by the IRS. Employers must make mandatory contributions to employees’ accounts, either as a matching contribution or a non-elective contribution, which benefits all eligible employees regardless of whether they contribute themselves.
Solo 401k	Designed for self-employed individuals or small business owners with no full-time employees other than the business owner and their spouse. It allows higher contribution limits and provides the same tax advantages as a traditional 401k.
SIMPLE 401k	Stands for Savings Incentive Match Plan for Employees. It is designed for small businesses with fewer than 100 employees. Employers are required to make either a matching contribution or a non-elective contribution. The contribution limits are lower compared to traditional 401k plans.
Self-Directed 401k	Offers more investment options beyond traditional stocks, bonds, and mutual funds. It allows participants to invest in alternative assets such as real estate, precious metals, private equity, or promissory notes. It requires a custodian or trustee to manage the plan.
Automatic Enrollment 401k	Encourages employee participation by automatically enrolling eligible employees in the plan unless they opt out. Employees can set their contribution rate and investment choices. It helps increase retirement savings rates but requires employees to actively manage their plan.
Non-Qualified 401k	Not governed by the same rules as traditional 401k plans. They are typically offered to highly compensated employees and provide a way to save additional retirement funds beyond the contribution limits of traditional plans. Contributions are made on an after-tax basis.

Note: The chart provides a general overview of different 401k plan types. It’s essential to consult with a financial advisor or plan administrator for specific details and rules applicable to each type of plan.

Opening a Solo 401k

So, how do you open a solo 401k? You generally need to have some sort of business, but it can be as simple as a sole proprietorship, a partnership, or a corporation. Financial institutions like Fidelity, Charles Schwab, or Vanguard are typical providers and will walk you through the setup. Remember, it’s your gig, so you’ll manage the solo 401k, including making contributions, choosing investments, and keeping up with IRS rules.

Contribution Rules for Solo 401k

The solo 401k is unique because you can contribute both as an employee and an employer. As the employee, you can contribute up to $22,500 (as of 2023). If you’re 50 or older, you can throw in an additional $7,500 to “catch up” on your savings.

Then, as the employer, you can contribute up to 25% of your compensation until the overall maximum. As of 2023, the overall maximum contribution amount is up to $66,000 (or $73,500 if age 50 or older) to an individual/solo 401k, depending on your income.

The specifics can get complicated here, so a tax professional can help determine your maximum contribution.

Penalties for Early Withdrawal

And now for a bit of a downer. Think again if you want to dip into that 401k before you hit 59½. Generally, the IRS will hit you with a 10% penalty on top of income taxes. There are some exceptions, like if you’re buying a first home or facing certain medical expenses, but generally, it’s best to let that money marinate until retirement.