5 Advantages of a Self-Directed Solo 401(k) Plan for the Self-Employed

Daniel Penzing
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Self-Directed Solo 401(k) Retirement Plan

More and more self-employed individuals are taking advantage of a self-directed solo 401(k) retirement plan to save for retirement. In addition to the traditional IRA, self-directed solo 401(k)s offer the self-employed freedom from high-cost investments and penalties for early withdrawals.

Self-directed investments enable the entrepreneur to diversify his or her retirement portfolio with virtually any investment, including real estate, precious metals, and small business investments.

Unlike a traditional 401(k) plan, self-directed investment decisions require the approval of an advisor, and any self-directed retirement plan can be as conservative or aggressive as the investor wishes. This increases the degree to which the self-directed plan meets the needs of the business owner.

Five Features That Give Self-Directed Solo 401(k) Plans an Unfair Advantage

A Solo 401(k) plan is a qualified retirement plan for self-employed individuals with no other employees. Since you are the only employee, you don’t have to worry about other employees that make pension and profit sharing contributions; the Solo 401(k) plan is your pension and profit sharing vehicle in one!

According to the IRS, the Solo 401(k) plan doesn’t have many restrictions:

  • Self-employed persons with no employees other than a spouse.
  • Partners who did not work for the partnership during the year.
  • Sole proprietors and partners who did not work for the business during the year.
  • A business that is owned and operated by a spouse and an employed spouse.
  • A business owned and controlled by a corporation and one or more of its officers who elect to make a profit-sharing or 401(k) contribution on behalf of an established plan. These contributions still must be allocated to those employees who were employed for the entire year.

Higher Contribution Limits

Contribution limits are only a portion of the overall benefits of a self-employed 401k. In addition, self-directed solo 401k plans allow you to contribute up to 25% of your net earnings from self-employment (compared to 20% for a traditional 401k). This can be a significant benefit if you are just starting out and may not be able to make such a high level of contributions in the future.

More Investment Choices:

Most plan providers will offer a standard list of investment choices. However, some plan providers offer more than 1,000 possible options (this can be very costly). If investing in alternative assets interests you, a solo 401k can be the perfect vehicle to pursue these types of investments.

DRIPs are Available:

Dividend Reinvestment Plans (DRIPs) are a great way for equity investors to accumulate more shares of their investments. DRIPs allow investors to reinvest their dividends automatically at little or no cost. Most brokerages will require a broker to sell stocks for DRIPs, whereas a solo 401k will allow you to set up a DRIP directly.

Minimize Taxes:

Alternate Investment Options

The Solo 401(k) account allows the account holder to choose his/her own investment options, such as stocks, bonds, mutual funds, and even alternative assets.

Typically, the first investment options that come to mind when talking about self-direction with regard to a Solo 401(k) plan are stocks, bonds, mutual funds, and the like. But in recent years, financial service providers have begun offering more alternative investments as well. As the push towards a more diversified retirement savings strategy continues to grow, the more available alternative investment options become.

Alternatives have received a lot of positive press over the last few years. Some of the most popular alternative investments that are available as choices on the Solo 401(k) plan include:

  • Real Estate
  • Peer to Peer Lending
  • Oil and Gas
  • Commodities
  • Private Placements

Just to name a few.

Investing in these volatile assets have the potential to skyrocket returns in the future. But they can also experience significant setbacks. While the Solo 401(k) plan as a whole may include diversification, the particular investments within a Solo 401(k) plan can lead to its exposure to certain highly volatile assets.

Complete Investment Discretion

Since Solo 401(k) plans are taken care of by you, you have complete control over your investment choices. From stocks to bonds to mutual funds, you have the ability to invest whatever you want into your Solo 401(k).

The only restrictions on your selection will be those imposed by the company that administers your plan. As you select an investment for your Solo 401(k), you need to make sure that it is suitable for a tax-deferred account such as a Solo 401(k).

Totally Flexible

Since you are responsible for taking care of your Solo 401(k), you can provide your plan with a certain degree of flexibility. In most other employer-sponsored plans, your investment options depend on the decisions of your company and your plan provider.

With a Solo 401(k), you can take matters into your own hands and invest your money as you please.

Keep in mind that a Solo 401(k) plan has certain limitations which make investing in non-traditional options more difficult. For example, there are strict tax laws governing the use of a Solo 401(k) plan for real estate purchases. However, if you are mindful about these limitations, you can still invest in some non-traditional options, such as real estate.

Participant Loans

No Borrowing Allowed

Tax Savings: The advantage of starting a Solo 401(k) plan is the opportunity to save taxes now and defer paying taxes to a later date, rather than having to pay taxes as you earn income. You can also start a Solo 401(k) plan with either taxdeductible or Roth contributions. This allows you to choose how you want your income taxed – today or in the future.

Flexibility of Investment Choices: Your Solo 401(k) plan will give you the ability to chose your own investments from a wide variety or mutual funds, stocks, bonds and a self-directed brokerage account. It is important to research these investment choices and educate yourself so that you can make wise investment decisions as your retirement retirement approaches. Those who fully understand the investment choices they have available in their plan tend to benefit more in the long run.

Highly Qualified: Employers offering Solo 401(k) plans must choose highly-qualified retirement plan professionals to administer the plans, provide fiduciary oversight, and interpret plan rules and regulations.

Roth Saving Option

Individuals can elect to have contributions automatically withheld from their earned income and deposited into a Roth 401(k) account. The contributions are made on an after-tax basis and earnings will be subject to tax upon withdrawal.

A Roth 401(k) is organized as a trust or a custodial account, depending on the rules for the plan. As a plan fiduciary, the sponsor has to approve requests for after-tax contributions. Most 401(k) plan sponsors don’t approve automatic Roth contributions, since most self-employed persons don’t have control over their deductions.

If you’re able to make after-tax contributions to a Roth 401(k) you can withdraw them completely tax-free, even if you’re no longer employed by the company that sponsored the plan.

3 Rules You Must Know About Solo 401(k) Plans

I’m a big fan of self-directed Solo 401(k) plans for the self-employed. They offer much more in the way of investment choices than traditional self-directed Keogh plans, and they provide an easy way to diversify your retirement income plan when you’re small. Plus, unlike other plans, investors aren’t subject to the sometimes-punishing required minimum distribution requirement at age 70-1/2.

Caveat: Solo 401(k) plans are available to self-employed people. So if you work for a public company, you’re out of luck. Also note that a solo 401(k) plan is not a business structure. It’s merely an investment vehicle. If you want to incorporate, you still have to do that separately.

Now let’s dive in. Here are the rules that make Solo 401(k) plans so attractive:

Annual Contribution Limits