The Pros and Cons of a Solo 401(k)

A Solo 401(k) plan is often considered to be the best self-directed retirement plan available.

Solo 401(k)s offer high contribution limits and can invest in a variety of assets, while also giving the account holder checkbook control. The Solo 401(k) is the most flexible and controllable investment portfolio available.

The Solo 401(k) is a powerful retirement plan option, but it might not be the best option for every retirement investor. Some people try to sell the Solo 401(k) to others even though it might not be the best option for them.

It is critical to your investing success to have a plan that fits both your current situation and your long-term goals. A Checkbook IRA LLC may be a better option than the Solo 401(k) for many investors.

When looking into a Solo 401(k) as a possible self-directed investing platform, there are a few key questions to keep in mind.

Do I Qualify for a Solo 401(k)?

A business is needed to establish a Solo 401(k) as an employee benefit. The Solo 401(k) is easy to manage because it is only for businesses with a single owner.

This means that to qualify, you must be self-employed and have no qualifying non-owner employees (other than a spouse). An employee who meets the requirements for eligibility is one who works full-time, for more than 1000 hours per year, or (as of 2021), a part-time employee who has worked for at least 500 hours per year for 3 consecutive years. Since your business isn’t providing benefits to employees who aren’t owners, the requirements for the plan are much simpler.

This means that if you own your own business, you may be able to set up a Solo 401(k) retirement plan. The business needs to make money through earned income, such as commissions, 1099 income from independent contractors, or wages from a corporation. Passive investment earnings from sources such as rental income cannot be used to sponsor a Solo 401(k).

What To Look For In A Solo 401k

I have learned a lot about what to look for when shopping around for a solo 401k provider. When you are looking for a 401k, there are many options and details that you should take into account. prototype plans are offered by many “free” providers and are simple and generic. If these don’t work for you, you can have a third party provider create a custom 401k plan for your business, which you can then take to a brokerage (these are called non-prototype plans).

Whoa, that sounds confusing, and it can be. There are several things you should take into account when trying to pick a provider for your 401k account.

Does the 401k provider offer both Roth and Traditional contributions ?
Does the 401k provider offer after-tax contributions to do a mega backdoor Roth IRA .
Does the 401k provider offer loans from the plan?
What types of investment options are allowed in the plan (i.e. can you invest in alternative assets like real estate, startups, or even cryptocurrency )?
Does the provider allow rollovers into the plan and rollovers out of the plan?
The costs to maintain the plan
The costs to invest within the plan

If you are looking for a solo 401k provider, there are many things you will need to compare to find the best one for you. Consider your wants and needs when making your decision. We can compare some of the main firms that offer solo 401ks to see which one is right for us.

Why A Solo 401k

What are the benefits of a solo 401k compared to a SEP IRA or other retirement options for self-employed individuals? This is all determined by your circumstances and how much money you can save.

Here are two similar scenarios to the example. In the past, this man only saved in a SEP IRA because his income was lower and he was still maxing out his 401k at work, so he didn’t need any additional employee contributions. However, now that he has a higher income, he is able to save in both a 401k and a SEP IRA.

If you make $30,000 a year and have a SEP or Solo 401k, your employer will contribute $5,576.11. Although he was earning $20,500 at his primary job, the extra money didn’t make a difference.

The business has grown and now makes more money than before. My wife now works for the company. It can save a lot of money and lower our taxes. Assuming the business will make $100,000 this year. This allows the company to contribute $18,587.05 to both the husband’s and wife’s 401k retirement savings. In addition, his wife can contribute $20,500 of her salary to the 401k as well (since he still makes $20,500 at work).

The solo 401k provides more savings options and lower taxes than other retirement accounts. The reason you can make both the employer and employee contribution when you are self-employed is because there are limits in place!

Will I Benefit?

The benefits of a Solo 401(k) over an IRA-based self-directed plan include: -The Solo 401(k) has higher contribution limits than an IRA. -The Solo 401(k) offers more investment options than an IRA. -The Solo 401(k) has more flexible withdrawal options than an IRA. Some of the more notable differentiators include:

A streamlined structure with no custodian involved
Higher contribution limits than most IRA plans, topping out at $63,500 per year
The ability to hold both tax-deferred and Roth funds in the same plan
The ability for a husband and wife to both participate in the same plan if they are both active in the sponsoring business
The option to borrow up to $50,000 from the plan on a participant loan
Exemption from UDFI taxation on debt-financed real estate investments
Less risk in the event of a prohibited transaction

These are all great features. The question is, what does that mean for you?

Does your self-employment generate significant income to the point where you can actually make higher contributions?
Will your spouse also have funds to hold within the plan?
Do you intend to invest in leveraged rental properties?

If none of the previous mentioned factors are relevant to your case, a IRA-based program that is permanent and straightforward may be a better option for you.

Does the Benefit Outweigh the Costs?

If you have a legitimate form of self-employment, great. Adding a Solo 401(k) will be a good solution for you.

The biggest advantage of a Solo 401(k) is that you can contribute more money to it, but if you’re only setting up a side business, you probably won’t be able to take advantage of that. You can’t put $63,500 in your 401(k) if the business supporting the plan is only making $3,000.

We regularly speak with investors who have discovered something beneficial about the Solo 401(k), for example the tax exemption on mortgaged real estate investments. Even if someone may not have legitimate self-employment, they may still want a Solo 401(k) account.

It is always advantageous to avoid paying taxes, unless the cost of avoiding taxes is greater than the amount of taxes owed. It is not worth setting up a side business, taking time away from family or other interests, keeping records, and filing taxes for that business to avoid the $200 a year in UDFI taxes an IRA might pay on a typical leveraged single-family rental.

Probably not.

If you have a 401(k) worth a million dollars, it might be worth becoming self-employed to take advantage of slightly lower UDFI taxes on that scale.

theory and reality only differ in the small details of a specific situation, so be sure to ask all the right questions and not get caught up with shiny object syndrome.

Thinking Long-Term Equals Success

When considering a self-directed retirement plan, it is important to evaluate it from a long-term perspective. We focus on helping our clients choose the right plan for their situation and goals to increase their chances of investment success.

If you find out that the plan you’re on isn’t right for you two years down the road, you’re in a bad situation. A real analysis of your specific needs is the best approach to transitioning into a self-directed investment strategy.

We believe that the Solo 401(k) plan structure is a great fit for about 30% of the investors we work with and offer our support. We also enjoy getting to see the successes of those investors who use the IRA LLC.

Some of the benefits to having a Solo 401(k) include being able to borrow money from the plan.

Comparing The 5 Most Popular Solo 401k Providers

The most popular providers of free Solo 401K plans are E-Trade, TD Ameritrade, Fidelity, Vanguard, and Charles Schwab.

If you have over $50,000 in assets with Vanguard, you don’t have to pay annual fees. Additionally, there are plenty of firms that provide commission-free exchange-traded funds, meaning you could invest in your Solo 401k without paying any fees. Vanguard also have a very odd pricing schedule. Although they do not charge a commission for their own products, if you want to purchase stocks or ETFs from other companies, you will be charged $2-$7, depending on the amount of assets you have.

The difficulty in choosing a provider for a solo 401k arises from the many options available. The choice of company depends on what is important to you, as each one has its own strengths and weaknesses. E*TRADE is the best option for people who want extensive options.

If you don’t find any of these options exciting, you can always create your own solo 401k with a third party provider.

Third Party Solo 401k Providers (Non-Prototype)

If you want a more robust solo 401k than the free prototype plans these five firms offer, you need to find a third-party service to create the plan documentation for you.

Some of the common reasons why you’d consider using a third-party service to create your solo 401k documentation:

You want a choice in brokerage
You want to invest in alternative assets such as real estate, startups, cryptocurrency, promissory notes, tax liens, precious metals, and more.
You want checkbook control over your 401k
None of the prototype providers matches exactly what you’re looking for with options

You can still invest with your favorite firm even if you go with a third-party provider. A solo 401k can be created through a third party, such as Fidelity. Fidelity’s investment choices are not determined by the plan.

How is this possible? Your plan provider creates the documents that govern your 401k plan. After you have selected the documents you want, you can take them to a broker of your choice, such as Fidelity or Schwab, and open a non-prototype account. These accounts hold your equity investments and manage them. They do not handle any of the paperwork associated with your plan. Did you withdraw from your plan? You’re responsible for creating the 1099-R.

preparation of annual plan documents, including any 1099-Rs or the 5500-EZ, with your plan provider

You can use these plans to do a Mega Backdoor Roth IRA. There are lots of companies that say they offer this service.

This isn’t an exhaustive list. In addition to national companies that provide 401k plan documentation, there are usually also local firms that can do this in most areas.

Conclusion

When deciding if a solo 401k is right for your small business, think about what benefits are most important to you. You will need to keep track of your own 401k information if you have one. If you are choosing to self-direct your investment, you may also want to consider a Self-Directed IRA.