A Guide On Individual 401(k) Plans For The Self-Employed

By Ronald Kimmons. May 7th 2016

A 401(k) plan is one of several types of tax-sheltered retirement plans recognized by the IRS. Under certain conditions, working people can contribute their taxable income to a 401(k) plan and defer the payment of taxes on that income until later. Employers may also make tax-sheltered contributions directly into their employees' 401(k) plans. While people generally refer to such plans in terms of an employer-employee relationship, there are retirement savings options for self-employed individuals as well. 401(k) plans for self-employed people are often referred to as Solo 401(k) plans. This article will discuss the basics of these Solo 401(k) plans.

The Advantages Of Solo 401(k) Plans For The Self-Employed

In the past, self-employed people have often viewed the 401(k) option as being inferior to other options, such as IRAs, because of the relatively high management costs. However, reforms in recent years have brought down these costs, allowing the advantages that 401(k) plans have to make them more popular among self-employed people. One of these advantages is that a 401(k) plan allows self-employed people to prepare for retirement by investing in a broader range of investment vehicles including real estate, private companies and just about any other type of investment opportunity. Another advantage is that, under certain conditions, people with funds in 401(k) accounts can deal with unforeseen financial obligations by borrowing from their 401(k) accounts. (Such borrowing is generally not allowed in other tax-sheltered investment plans.)

Requirements To Opening A Solo 401(k)

To open a Solo 401(k) plan and enjoy the associated tax benefits, one of the following must be true:

  • You own a business in which there are no employees other than yourself and/or your spouse.
  • You have other people who work for your business, but they are independent contractors. (For a helpful independent contractor tax guide, see Tax Guide For Independent Contractors.)
  • All of your employees are 21 years of age or younger.
  • None of your employees work more than 1,000 hours per calendar year.

Types Of Contributions Allowed

Self-employed individuals may make three different types of contributions into their Solo 401(k) plans:

  • Salary Deferral – This is the main type of contribution that investors make. It is calculated as a portion of a self-employed person's income that would otherwise be taxable.
  • Catch-Up Contribution – Investors who are 50 years of age or older may make catch-up contributions in addition to their normal salary deferrals. These contributions are designed to help older people with insufficient retirement savings to “catch up” in time for retirement.
  • Profit Sharing Contribution – This is a contribution that self-employed people may make based on the profits of the business, just as employees may receive contributions from their employers based on profit sharing.

Contribution Limitations

As with other tax-sheltered retirement plans, the amount of money that a self-employed individual may contribute to a Solo 401(k) plan is limited. As of 2012, the limitations for contribution into a self-employed 401(k) plan are:

  • $17,000 in salary deferral.
  • $5,500 in catch-up contributions.
  • Either 20 or 25 percent of business profits in profit sharing contributions (depending on business form).

Business Form: Can Your Share 20 Or 25 Percent?

When it comes to calculating profit sharing contributions, the legal structure of a self-employed person's business is essential. If you are self-employed and you run your business as a sole proprietorship, you may invest as much as 25 percent of your net taxable income into your 401(k) as a profit sharing contribution. If your business is incorporated, your contribution limit for profit sharing is 20 percent of total business profits. If your business is an LLC, you may choose for it to be taxed as a pass-through entity (in which case you pay no taxes on the company level) or as a corporation (in which case you pay income tax for both the company and yourself). If you elect for your LLC to be taxed as a corporation, the 20 percent limitation applies.

Setting Up A Self-Employed 401(k)

If you have decided that setting up a Solo 401(k) is your best option when it comes to preparing for retirement, you may theoretically do so on your own. However, due to the complex tax implications involved with the account, only large companies tend to do this task in-house. Medium-sized and small businesses usually go through an outside party to set up their 401(k) plans. Such outside parties may be banks, investment firms, mutual fund providers or insurance companies. To avoid the headaches and extra work involved with setting up and maintaining the account, it is advisable that you go through this route for your Solo 401(k).

What Is ROBS?

The acronym “ROBS” stands for “rollover as a business startup”. This term is used to refer to a specific type of 401(k) investment that is often a consideration for those who are self-employed. It allows investors to use tax-deferred funds to pay for the startup costs of new businesses. Investors make the decision to invest in ROBS schemes because, after all, a 401(k) does allow you to invest in private businesses – so why not use it to invest in your own private business? However, while a ROBS transaction can be a very tax-efficient way of both saving for retirement and starting a business, and while it is technically legal, the IRS generally frowns upon it. Those who engage in ROBS transactions not only risk their retirement on potentially unstable business ventures, but they also tend to invite the IRS to audit them. For these reasons, most financial advisors discourage such use of retirement funds. (To learn more about the other IRS audit red flags, see 5 Tips To Avoid An IRS Tax Audit.)

A Solo 401(k) is a great way for self-employed people to efficiently and safely save for retirement. If you are self-employed and looking for a way to save for retirement, contact a 401(k) provider to get started.

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