Why I Chose a Solo 401k While Self-Employed on the Path to FIRE
A Solo 401(k) can be a great option to boost your retirement savings.
I started working as a freelance content writer a year and a half ago when I began coasting to financial independence. This is my first official foray into the world of freelancing and entrepreneurship, and it has been such a fun ride so far.
It’s a beautiful way to work: setting my own schedule, scaling up or down as I want, taking the jobs I like and passing on the ones I don't, and of course, never having to ask a boss for a day off.
In the beginning, jobs were sparse, and my income was low. So I started by finding personal finance writing gigs through Upwork and slowly pieced together a list of clients. Over time, I’ve gotten more skilled at my craft and consistently raised my rates, allowing me to stack some profit in my business checking account.
Eventually, I reached a point where I began to think of all the different ways I could use the money in my business account and decided that I should just start a Solo 401(k) before I go and invest it all into various cryptocurrencies (nothing against crypto, I’ve just hit the limit of how much I want to have invested.)
What is a Solo 401(k)?
A Solo 401(k) is a tax-advantaged retirement plan for self-employed individuals. Solo 401(k)s can be an excellent option for business owners with no employees or a spouse as their only employee.
Similar to a 401(k) offered through your employer, a Solo 401(k) has annual contribution limits and allows you to put money in pre-tax (Traditional) or after-tax (Roth). In addition, since you’re self-employed and assume the role of the employee and the employer, you can make contributions based on your earnings as the “employee” and then on net profit as the “employer.”
You can find the annual contribution limits on the IRS website as they change over time.
Pros of a Solo 401(k)
While there are many different options for saving for retirement, here are some of the reasons I decided to set up a Solo 401(k).
You can put away a lot of money.
They can be easy to set up.
They can be very inexpensive.
Contributions
When it comes to retirement plans for self-employed individuals, the two most common options are SEP IRAs or Solo 401(k)s. I chose to go with a Solo 401(k) because I can contribute more of my earnings to a Solo than a SEP.
Solo’s are great because they allow you to contribute 100% of your first $20,500 of earnings, (minus one-half of your self-employment tax.)
Said another way, if you earned $20,500 in your business, you could contribute (almost) all of that to your Solo plan in 2022 (~19,000 after subtracting half of your self-employment tax.)
In contrast, a SEP IRA limits you to 25% of your adjusted net earnings. So if you earned $20,500, you would only be able to contribute $3.8k to your SEP, as you have to adjust the $20,500 down to “adjusted net earnings” and then multiply by 25%. So for that reason alone, a Solo 401(k) was a clear choice for me.
If you want to play around with contribution calculators, here is one from the Oblivious Investor for Solos: Solo 401k Contribution Calculator, and one for SEPs: SEP IRA Contribution Calculator.
However both plans max out at $61,000 for 2022, so at a certain level of income (~$320k), the solo 401(k)s advantage diminishes. But, I’m not making $320k per year from my writing yet, so the Solo plan made the most sense for me.
Costs and Set-up
Also, there are so many tech-enabled Solo 401(k) providers specifically designed for small businesses nowadays that set-up is an absolute breeze and the costs are crazy low. For example, I used a provider named 401GO and set up my Solo plan in about 15 minutes, and the total cost is $9 per month. I feel I am getting a great deal for the price and the product and couldn’t be happier.
Now that I have my Solo 401(k) established, I’m able to make a decision each year about how much I want to contribute to my plan, allowing me to either reduce my taxable income with traditional pre-tax contributions OR lock in a favorably low tax rate in lower-income years with a Roth contribution.
Another great Solo 401(k) provider that many small businesses use is Guideline. They offer Solo and regular 401(k)s for small businesses with low fees and an easy set-up.
Cons of a Solo 401(k)
So why wouldn’t you set up a Solo 401(k)?
Well, the biggest downside to setting up a Solo 401(k) has traditionally been the administrative burden and the cost. But thanks to the proliferation of tech-enabled small business solutions, those barriers to entry have largely been eliminated.
In addition, and this is less of a con and more of a limitation, but you cannot have a Solo 401(k) if you have employees other than your spouse. You need to go with a regular 401(k) and offer it to all eligible employees if you have employees.
Should you set up a Solo 401(k)?
Whether or not you should set up a Solo 401(k) comes down to a variety of factors, but let’s explore them together.
First, if you’ve got self-employment income and are looking to set up a retirement plan, then I think a Solo can be a great way to go. IMO it beats out a SEP because you can contribute so much more if your self-employment income is below $320k.
Second, if you are already maxing out a Roth or Trad IRA and have self-employment income you’d like to save, a Solo can be a great next place to save for retirement.
Third, if you want to decrease your tax liability, a Solo can be a great option, allowing you to stuff away up to $61k per year pre-tax. That’s a powerful tax planning lever you can pull on to control your taxable income as a self-employed person.
That said, a Solo may not be a good fit for you if:
You don’t have any extra money to save in your business.
You are focused on building cash reserves in your business.
Your business is new, and your income is unpredictable.
In the end, I love having a Solo set up and knowing that each year I get to look back, assess my situation and decide whether I would like to contribute to my 401(k) or not. It’s just another financial planning tool I have at my disposal, AND it is accelerating my path to FIRE by allowing me to limit my tax liability, control my income, and save in a tax-advantaged account, all for the low cost of 9 bucks a month.
Do you have a solo 401(k) or questions about one? Let me know in the comments below!