Do you qualify for a self-employed 401(k)?

LAST REVIEWED Oct 29 2020 8 MIN READ

By The Human Interest Team

Are you a self-employed professional planning for your retirement? A self-employed 401(k) is an excellent plan to build out your retirement nest egg. Whether you are a freelancer, shop owner, or small business owner without employees, a solo 401(k) retirement plan can help you live your dream life when you retire. Here we’ll discuss an overview of a self-employed 401(k), setting one up, how to withdraw from the account and other vital information. 

Understanding Self-Employed 401(k)s

A self-employed 401(k), also called individual 401(k) or solo 401(k), is a savings plan for sole proprietors, independent professionals, and other small business owners who have no employees except for a spouse. It is a retirement option similar to what large employers provide for their employees. 

As a self-employed individual, you can use other retirement plans such as a Roth or traditional IRA, and the SEP IRA. But a solo 401(k) allows you to make higher contributions than these other options. 

How Does a Self-Employed 401(k) Work?

The solo 401(k) is like the classic 401(k). You contribute into the account from your pre-tax income, and you can invest the savings without paying taxes. However, you will pay taxes on withdrawals when you retire. A self-employed 401(k) allows your spouse to contribute in the same plan. 

A major difference between an individual 401(k), a standard 401(k), and other personal 401(k) options is that you can make more contributions. If you qualify for a self-employed 401(k), the higher contribution restrictions, and easy administration of the account, makes it an ideal choice for retirement savings. 

What Are the Ways to Contribute to Self-Employed 401(k)?

You can contribute to an individual 401(k) account as an employee and an employer. As an employee, the solo 401(k) limits for 2020 allow you to contribute the lesser of either $19,500 (same in 2021) or 100% of your income. Participants who are 50 years and older can increase their contributions by $6,500 each year for a total of $26,000. 

As an employer, the 2020 guidelines permit you to contribute up to 25% of your annual compensation, and up to a maximum of $57,000 in combined contributions per year. For 2020, the IRS limits the self-employed 401(k) contribution of participants 50 years and older to $63,500. 

A solo 401(k) plan offers tax breaks if you are eligible. You can deduct the contributions from your personal income if you did not incorporate the business. If you run a corporation, you can classify the contributions as a business expense. 

How Do You Set Up a Self-Employed 401(k)?

It is easy to set up a self-employed 401(k) plan with many 401(k) administrators. You can also open a solo 401(k) online. To set one up, you will need an Employer Identification Number (EIN), which you can get from the IRS. You also need to complete a plan adoption agreement and an account application. Self-employed 401(k)s are easy to administer and attract low maintenance fees because they involve only one or two people. 

Before choosing a plan administrator, it is important to compare their fees before you sign up. You may also want to choose an administrator that allows you to invest your retirement savings into a broad range of assets including mutual funds, ETFs, CDs, stocks, and bonds. Other features to look for include 24-hour multi-channel support, investment advisory, low fees, and positive customer reviews. Once you’ve completed the paperwork, and the plan becomes active, the only thing you have to do is to set contribution levels and choose investments. 

Self-employed 401(k) plans have no annual minimum contribution requirements. In good years, you can make the maximum contributions and reduce your savings when the cash flow is low. But once you have up to $250,000 in the account, you must file IRS Form 5500-EZ to report the financial status of your solo retirement plan to the tax authorities. 

Who Can Have a Solo 401(k) Plan?

You can open an individual 401(k) if:

  • You make self-employment income through a product or service such as working as an independent contractor, painting, or driving for ride-hailing companies. 

  • You own a sole proprietorship, a limited liability company, limited partnership, S corporation or, C corporation

  • You are the only employee in your business.

What Are Some Regulations on Self-Employed 401(k) Plans?

The self-employed 401(k) plans have several regulations designed to help you contribute towards retirement. Here are the main solo 401(k) rules:

  • If you withdraw from the account before age 59½, you may pay a 10% early withdrawal penalty and applicable income taxes.

  • Once you reach age 72, in accordance with the SECURE Act,* you must take Required Minimum Distributions (RMD). 

  • You may structure the plan to fund loans and hardship distributions.

  • They may transfer savings from another compatible 401(k) plan or an IRA account into a self-employed 401(k).

  • If your business adds employees later, you must either convert the solo 401(k) to a standard 401(k) or close the account. 

What Are the Factors That Differentiate the Solo 401(k) From an Employer 401(k)?

Three main factors distinguish a self-employed 401(k) plan from an employer 401(k) including:

  • You are the employer and employee on the plan as the business owner.

  • Solo 401(k) plans allow you to make far higher contributions to your retirement plan than if you are an employee in an employer 401(k).

  • Any self-employed person can open a solo 401(k) plan regardless of the product or service you provide. 

You can also run a self-employed 401(k) account as a self-directed plan. It allows you to invest your contributions on specific assets with an investment broker trustee. 

A solo 401(k) plan is ideal if you want to set up a retirement plan as a self-employed person. It has the highest contribution restrictions, which allows you to grow your retirement savings faster and you can also enjoy solo 401(k) tax benefits. It is also easy to set up and administer. 

Self-employed 401(k) plans give you complete control of your investment choices if you open them in a self-directed brokerage account. If your business hires employees at a later date, you only need to convert the solo 401(k) account into a standard employer 401(k) plan.

We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.

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