The solo 401k is ideally suited for successful Millennials setting themselves up as single-employee businesses making enough money in the “gig” economy to start thinking seriously about tax-advantaged saving for retirement. The 2019 maximum deductible contribution of $56,000, possibly doubled by a contribution for an eligible spouse working in the business—no matter the ages of the plan participants—can be a powerful incentive to get serious about the long-term future. Of course, the solo 401k can be useful for older GenXers too and even for Baby Boomers who have become consultants to the corporations and/or industries that have laid them off as full-time W2 employees.
Whenever the right fact pattern presents, Integrated Retirement Advisors quick to recommend this plan. The key is for the business owner to be making enough money to take advantage of the plan’s generous capacity and low-cost simplicity. Another determinant is the expectation of doing so in future without the need to hire employees. Once employees (other than a spouse) enter the picture, the solo 401k plan must be converted to a standard employer plan that gets more complicated (due to non-discrimination testing) and more expensive (due to additional operating and administrative costs). Of course, every contribution to a solo plan can incent and boost a retirement investing effort, so even setting one up for a few years while a business scales up can be very advantageous.
Limited access to the plan’s accumulating account is probably the greatest drawback to this arrangement. Like any tax-qualified plan, once a contribution is made access to the funds is limited by IRS regulations. Withdrawals before age 59-1/2 are subject to income tax plus a 10% premature withdrawal penalty. Solo plan loans of up to $50,000 can be taken, but they’re tax-inefficient and must be repaid with interest over five years. If they default, they too can generate early withdrawal penalties.
In terms of investment, the more diversified and flexible the platform, the better. Providers come in a variety of shapes and sizes. The big brokerages offer prototype plans that may limit their offerings to stocks, bonds, funds and ETFs. Some securities boutiques offer self-directed plans that provide access to real estate, precious metals and other alternatives, including bitcoin!
We make it a point to inform clients that 401k plans, including the Solo variety, permit insurance contracts as investments. Today’s fixed index annuity (FIA) can provide market-linked growth potential together with downside protection, a combination that lends itself well to long-term compounding. Integrated with securities, these contracts can help de-risk a retirement portfolio without necessarily imposing an unbearable opportunity cost. Roger Ibbotson’s recent research suggests they’re worth considering as a bond alternative.
Life insurance is also a permissible alternative in a Solo 401k plan. When permanent coverage may be needed for personal and/or business reasons, funding it pre-tax in a 401k plan can prove very cost-efficient. Given enough time, index-linked life contracts can provide temporary protection together with investment growth. Once the protection feature is no longer needed, the contract can be surrendered for its cash value that is then added to the account’s aggregate holdings.
