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Grow Your Business Finances

Self-Employed 401(k) Plans: Frequently Asked Questions

image for Kinga/Shutterstock
Kinga/Shutterstock
  • Individual 401(k) plans allow you to start taking deductions after you turn 59.5 years old. 
  • You cannot employ any full-time employees and have a solo 401(k).
  • In 2019, an employee can contribute up to $19,000 in one year, assuming you're under 50 years old.
  • Annual or maintenance fees for solo 401(k) plans usually run between $20 and $200, and they are tax deductible. 

The number of people who run their own business continues to trend up. According to the Bureau of Labor Statistics, 9.6 million people worked for themselves in 2016, and that's projected to increase to 10.3 million by 2026.

Working for yourself may give you the ability to make more money than you would working for someone else, but it also means you need to have your own retirement plan in place. One of the most popular retirement plans for independent workers is a self-employed 401(k). We spoke to two financial experts to find out how these retirement plans work.

Logan Allec, CPA and owner of the personal finance site Money Done Right, and Adam Bergman, a trained tax attorney and president of IRA Financial Trust and IRA Financial Group, offered their insights about these plans, including the maximum contributions, taxes, investments and fees.

Editor's note: Looking for an employee retirement plan for your business? Fill out the below questionnaire to have our vendor partners contact you with free information.

 

Allec: This plan goes by many names, including solo, individual and single-k, but they all mean a 401(k) retirement savings plan for the self-employed person. You can contribute a large amount of money to this plan every year and then start taking distributions from the account after you turn 59.5 years of age.

Allec: I think that, for most businesses, the solo 401(k) is the best. Many small businesses can contribute more to a solo 401(k) than, say, a SEP at the same income level. With an IRA, you can only contribute $6,000 (50 years or under) or $7,000 (50 years or over) in 2019. With a SEP IRA, you can't contribute as both employer and employee, only as an employer. [Interested in employee retirement plans? Check out our reviews and best picks.]

Allec: 1. You're required to make self-employment income from your personal efforts; usually you generate a product or provide a service. You could also provide services as an independent contractor, like driving for Uber or working on a 1099 basis for a large company.

2. A sole proprietorship, limited liability company (LLC), S corporation, C corporation or limited partnership can all set up an individual 401(k).

3. Your business can't employ any full-time workers besides yourself.

Allec: You can't have any full-time employees, but you can contract with freelancers or employ part-time employees who don't work more than 1,000 hours a year in your business. Note that not all individual 401(k) plans allow for part-time employees, so be sure to check with your provider before hiring employees.

Bergman: You need to select a provider. One of the most common ways to establish one of these plans is to go through a bank. You usually aren't charged a fee for these, but your investment options are limited to the financial products the bank or financial institution sells. You can also go through a brokerage. In addition, there are self-directed solo 401(k) plan document providers, which do not sell investments and will allow you to establish a self-directed solo 401(k) plan to make alternative asset investments, such as real estate, as well as gain access to all other available plan options, such as Roth contributions and a $50,000 loan option.

Bergman: Start early – the younger, the better – and be consistent. Whenever you can, you want to defer taxes instead of paying taxes. You also want to maximize the amount of money you'll have in retirement.

To make plan contributions to a solo 401(k) for 2018, it needs to be set up by April 15, 2019. If you set it up after that date, all your contributions go towards 2019.

Allec: The contribution limits have both an employee and employer component. You fill both those roles. In 2019, an employee can contribute up to $19,000 if he is under 50. For those 50 or older, the maximum is $25,000. The $6,000 difference is a catch-up provision, meaning older individuals can save more for their retirement.

As for the employer component, you can make a nonelective (tax-deductible) contribution to the 401(k) of 25% of your Form W-2 wages. For example, if you earn $100,000 in wages in 2019, you can contribute $19,000 as an employee and $25,000 (25%) as an employer for a total of $44,000. For a sole proprietorship, the employer component is 20% of your net income from self-employment, which is calculated as your self-employment income as reported on Schedule C, less your deduction for half of self-employment taxes paid.

When you contribute as both an employee and an employer, the threshold amount is $56,000 if you're under 50 and $62,000 if you're 50 or older.

These limits usually change every year, and typically they go up to adjust for inflation. The increase is usually a round number, not a percentage.

If your spouse works for your business and is compensated, he or she can participate in your business's solo 401(k) at the same limits as above.

Bergman: In general, yes, a self-employed individual can make an employee deferral lump-sum contribution to a plan so long as he or she has sufficient earned income.  However, in the case of a W-2 owner/employee, the employee deferral contribution should not be more than the income earned for that income period. In the case of employer profit-sharing contributions, those can be made by the employer in a lump sum.

Bergman: Depending on the provider you choose to house your plan, you can invest in almost anything. However, if you select a financial institution to oversee your plan, you must invest in their products. Otherwise, opportunities remain limitless. Go the traditional route with stocks or mutual funds, or turn to alternative investments like real estate, gold or cryptocurrencies.

Allec: Annual or maintenance fees for these plans usually run between $20 and $200. You'll pay the least if your needs are simple – you don't have any employees besides yourself, there's no rollover, and you're OK with investing in a budget brokerage firm's products. If you have more interesting investment appetites, another provider can accommodate those. These providers usually charge higher fees to maintain your plan, but you also have more flexibility with your investment and plan options.

Bergman: Yes, by using your business funds to contribute to your 401(k), you're eligible to claim a deduction for the cost of the plan and its maintenance fees. This helps reduce your business's income tax obligation.

Bergman: You can borrow up to $50,000 or 50% of the account value, whichever is less, for any purpose at a low interest rate. As of March 1, 2019, the lowest interest rate was prime at 5.5%. To avoid taxes, this loan must be repaid within five years of the loan date, and payments must be made at least quarterly.

Bergman: In general, once the decision is made by the business to terminate the plan, the plan participant will generally have to move those funds during the course of the tax year, but it really should be done as soon as reasonably possible.

Allec: Overcontributing is the largest mistake. When you discover you've put too much money into your plan, call your provider right away. They can help you withdraw the overcontributed amount so you won't have to pay taxes on it.

Another common error is breaking one of the prohibited transaction rules. For example, your plan buys a house in Florida and rents it out as an investment. If you want to take a family trip to Disney World, you can't stay in that house. Once you've invested in alternative assets and break the rules, you will be subjected to taxes and penalties. Always make sure your provider goes over the prohibited rules with you when you open your individual 401(k).

The last mistake many people make is not getting their solo 401(k) set up by the end of the year.

Heather Larson

Heather Larson spent way too many years working in different finance departments. Now she writes about money along with business solutions and technology. When she's not writing, she relishes reading a good thriller with her rescue dog in her lap.