How a Solo 401(k) Is Taxed and What Is Deductible?

A self-employed worker reviewing rules to deduct contributions from his solo 401(k).

Investing in a solo 401(k) is a common retirement savings plan for self-employed individuals or small business owners. Let’s break down how it works, gets taxed and what potential deductions you can take. As with all retirement plans, how much you can save will depend on your specific circumstances. Therefore, getting personalized advice from a financial advisor could help you reach your goals.

How a Solo 401(k) Works

The solo 401(k), also known as a one-participant 401(k), is a retirement savings plan designed specifically for self-employed individuals or small business owners with no full-time employees other than their spouse. This plan allows for substantial tax deductions on contributions, significantly reducing your taxable income. However, the effectiveness of these deductions can vary depending on personal circumstances.

A self-employed individual who can make a maximum contribution of $66,000 in 2023 ($69,000 in 2024) to their solo 401(k). You can contribute $22,500 in 2023 ($23,000 in 2024) as elective deferrals and the employer, or your business, can contribute up to 25% of your compensation, but it must be defined by your plan.

To qualify for a solo 401(k), you must be a business owner with no full-time employees, other than a spouse, who generates self-employment income. If you fit this description, then you could benefit from higher contribution limits with a solo 401(k) than traditional IRAs, make tax-free growth of investments and get tax deductions on contributions.

How a Solo 401(k) Is Taxed

A self-employed worker tracking the progress of his solo 401(k).

Contributions to a solo 401(k) are usually made with pre-tax dollars, which reduces your current taxable income. However, the tax treatment is different when you establish a Roth account. For this type of solo 401(k), you would pay taxes upfront on your contributions. And consequently not be able to deduct them from your federal taxes.

Distributions are generally taxed as ordinary income, depending on the tax bracket that you fall into. Additionally, you should note that early withdrawals before age 59 1/2 may incur a 10% penalty on top of regular income taxes.

Potential Tax Deductions With a Solo 401(k)

The main tax perk involves reducing your taxable income through contributions made to the plan. All of your contributions are made in pre-tax dollars so you don’t earn as much money, for taxes, in the moment.

In 2023, the maximum deduction for solo 401(k) contributions is $66,000 ($69,000 in 2024). This can go up to $73,500 for those aged 50 or older ($76,500 in 2024). The amount that you can claim for tax deductions, however, depends on several factors such as your income, age and the type of contributions (employee or employer) you make.

To claim these beneficial deductions, ensure that contributions are made by your tax return’s due date and you gather all the necessary documentation, such as your W-2, 1099, or Schedule C. Claim deductions by entering your total contributions on line 28 of Form 1040 Schedule C for self-employed individuals, or on the deductions worksheet for corporations. For assets over $250,000, file IRS Form 5500-EZ.

If you’re self-employed and operate as a sole proprietor, partnership, or an LLC taxed as a sole proprietorship, you might be able to deduct contributions for yourself from your personal income.

Bottom Line

A small business owner checking tax requirements and deductions for a solo 401(k).

A solo 401(k) can be beneficial for self-employed individuals, offering potentially higher contribution limits, and allowing savers to benefit from tax advantages. Though, make sure you understand tax requirements for eligibility and deductions.

Tips for Tax Planning

If you want to make sure you’ll be as protected as you can be come tax time, you may want to enlist the help of an experienced financial advisor. They can help you make a financial plan that fully takes your taxes into consideration. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you’re curious whether you’re on the right path for your tax plan for the current year, consider using SmartAsset’s free income tax calculator.