Understanding 401(k) for When You’re Self Employed

If you are someone that is self employed, you know just how complex it can be. When people are setting up their business, many don’t realize just how many factors go into self employment. One big part of self employment that often gets overlooked is a 401(k). 401(k) Plans are a type of retirement savings account that is available through employers. However, people that are self employed are basically their own employers. That is why Self Employed 401(k) plans exist. They are known as Solo 401(k) plans. It can be a little tricky understanding how these retirement savings accounts work!

Understanding 401(k) Plans

Before we talk about Self Employed 401(k) plans, it is important to make sure you have a clear understanding of a standard 401(k) plan. A 401(k) plan is a type of retirement account that a lot of American employers offer. This type of retirement plan is popular because it comes with a variety of tax advantages. The type of tax advantages that you can get from this account vary depending on the type of 401(k) plan.

Once an employee signs up for a 401(k) plan, they will need to make contributions. Depending on the employer, they may choose to match a portion or all of the contributions of the employee. Employer contributions will vary depending on the employer and each employer has their own setup! This is a type of investment account so employees will have to choose from a variety of investment options. However, the investment options are typically mutual funds. Mutual funds would include stocks, bonds, etc.

Different Types of 401(k) Plans

When it comes to 401(k) plans, there are two main options that employers offer. It is important to know the difference between these two options because each opportunity comes with its own set of tax benefits. We will touch more on what it means to have a Solo 401(k) when we talk about 401(k)s for self employment later in the article! The two main types of 401(k)s are:

  • Traditional 401(k) Plans
  • Roth 401(k) Plans

It’s important to keep in mind that every employer is different. That means that not every employer will offer the same plan options or even investment options. These accounts also come with rules like contribution limits regardless of the type. The contribution limits for 2021 was:

  • $19,500 for employees under 50 years old
  • $26,000 for employees over 50 years old

However the limits changed for 2022. For 2022 the contribution limits are:

  • $20,500 for employees under 50 years old
  • $27,000 for employees over 50 years old.

The reason that employees over 50 years old can contribute more is due to catch up contributions. Catch up contributions allow employees who are closer to retirement the chance to “catch up” to reach their retirement goals!

Traditional 401(k) Plans

This is what a lot of people think of when a 401(k) comes to mind. This type of 401(k) is funded with pre-tax dollars. Why is that important? Well taxes have not been applied to the funds before they enter the account. That means employees can count their contribution as a tax deduction. The benefit of a tax deduction is the fact that it reduces the overall taxable income that a person needs to pay taxes on.

Let’s look at an example to paint a clearer picture! Let’s say that your taxable income for the year is $37,000. In that same year, you make a contribution of $4,500 into your Traditional 401(k). You can count that contribution as a tax deduction and reduce your overall taxable income to $32,500. This means you would end up paying less taxes! However once it’s time to take money out of the account (known as a distribution) it is a little bit different. That’s because distributions of a Traditional 401(k) are taxed at the standard income tax rate.

Roth 401(k) Plans

Besides a Traditional 401(k) there is a Roth 401(k). This account is different because it is funded with after-tax dollars. That means the funds that an employee contributes into this type of account have already had taxes applied to them. Even though that means employees can’t use their contribution as a tax deduction, they can see benefits down the line. That’s because once it’s time to take out a distribution, the funds will not face any additional taxes!

Understanding 401(k) for When You’re Self Employed

Now that you have a basic understanding of 401(k) plans offered by employers, it’s time to learn about what it means to have a Self Employed 401(k) plan. Also known as a solo 401(k), this 401(k) opportunity is a special retirement plan opportunity for small business owners that don’t have employees (besides their spouse). That means a solo 401(k) is a great opportunity for self employment professionals like independent contractors, small business owners, sole proprietors, consultants, and more.

What is a Solo 401(k)?

A Self Employed 401(k) is known as a Solo 401(k). It works similarly to a standard 401(k). However, there is one key difference to be mindful of! When it comes to a Solo 401(k), participants are basically both the employer and the employee. That means that they have the opportunity to contribute more annually than they could with a normal 401(k).

How Much Can You Contribute to a Solo 401(k)?

Many people don’t realize that a Self Employed 401(k) gives individuals the chance to save more than the typical 401(k) contribution limits. For a Solo 401(k), the limits for 2021 were:

  • $58,000 for individuals younger than 50 years old
  • $64,500 for individuals older than 50 years old

For a Solo 401(k), the limits also changed in 2022. The contribution limit for a Solo 401(k) in 2022 are:

  • $61,000 for individuals younger than 50 years old
  • $67,500 for individuals older than 50 years old

Benefits of a Solo 401(k)

Just like any decision you make in life, it is important to consider both the pros and cons. That’s because there are a variety of benefits and drawbacks that may impact how you feel about this retirement account. Some of the pros of a Self Employed 401(k) include:

  • High Contribution Limits
  • Tax Deductions
  • Potential Roth Component
  • Availability for a Spousal Solo 401(k)

High Contribution Limits

Like we said earlier in this article, a Solo 401(k) will have higher contribution limits than a standard 401(k). That is why people like this opportunity. Since employer contributions and employee contributions are made by one person, a Solo 401(k) allows people to contribute more.

Tax Deductions

When it comes to a Solo 401(k) you may be able to consider your contributions as a tax deduction. For example, let’s say you maxed out your contribution limit for 2021 and contributed $58,000 into your Solo 401(k) as a self employed person younger than 50 years old. You may be able to get a tax deduction worth that amount!

Potential Roth Component

When it comes to a Solo 401(k), you may be able to defer a Roth component. This would give you the opportunity to make deferrals into the account with after-tax funds. That means you have the opportunity to take funds out tax free (as long as you follow the rules). When you take out funds tax free that means you will not be responsible for any additional takes on the money you take out!

Availability for a Spousal Solo 401(k)

If you are self employed but have your spouse working for you then they could take advantage of the Solo 401(k). This is only available if your spouse is employed by your business and you pay them a wage or salary that they claim as income.

Drawbacks of a Solo 401(k)

Even though there are some nice benefits that come along with a Solo 401(k), there are still some drawbacks to be aware of. Some of the cons that come along with a 401(k) include:

  • No Employees
  • IRS 5500 Filing
  • Substantial and Recurring Contributions

No Employees

If you want to be eligible to get a Solo 401(k), there are qualifications you need to meet besides being self employed. You will not be able to have any employees (besides your spouse). So if you plan on getting employees in the future then this may not be the best option for you.

IRS 5500 Filing

The Internal Revenue Service (IRS) requires people to file an annual report on a Form 5500-SF if their account has $250,000 or more in assets by the end of the year. However, if your account has less than $250,000 then you may be exempt from the annual filing requirement!

Substantial and Recurring Contributions

The IRS also requires Solo 401(k) contributions to be substantial and recurring. This means in order for your Solo 401(k) to remain active, you will need to make contributions pretty regularly. Besides making regular contributions, the contribution amount needs to show an intention to continue the Solo 401(k). If not, then the contributions will be treated as discontinued.

Who Qualifies for a Solo 401(k)?

If you want to qualify for a Solo 401(k) you will need to meet these two qualifications:

  • Have Self Employment Activity
  • Not Have Employees (Besides a Spouse)

This plan is a popular option amongst self employed individuals like independent contractors, sole proprietors, consultants, and more.

How to Setup a Solo 401(k)

You can break down the process of setting up your Solo 401(k) into 3 easy steps:

  1. Make Sure You Understand Eligibility Requirements
  2. Get in Touch with a Solo 401(k) Provider
  3. Complete Any Documents and Disclosures to Open Your Account

We want to stress that the best way to learn about a Solo 401(k) is by getting in touch with a professional. They can answer any and all questions you have about this type of account. On top of that, they will help you understand how these accounts will work with your specific situation!

1. Make Sure You Understand Eligibility Requirements

The IRS has regulations around who can and cannot get this type of 401(k). That is why you want to make sure you are eligible. Besides being self employed and having no non-spouse employees, you will want to confirm qualifications with your plan administrator. They can answer any questions you have about Solo 401(k) eligibility.

2. Get in Touch with a Solo 401(k) Provider

This is one of the most important steps when it comes to setting up your Solo 401(k). That’s because your provider is going to be the one to administer your Solo 401(k). You will want to find a Solo 401(k) plan that is straight to the point, simple, and cost effective. The best plan will be one that considers your current situation and future goals! When looking for a Solo 401(k) provider you will want to keep these 3 aspects in mind:

  • Cost of the Plan
  • Level of Management
  • Investment Flexibility

3. Complete Any Documents and Disclosures to Open Your Account

Once you find your Solo 401(k) provider you will need to review documents and disclosures in order to set up your plan. Typically your provider will give you documents which can include the following:

  • Adoption Agreement
  • Client Agreement
  • ERISA 404(c) Plan Information
  • Establishing a Qualified Retirement Plan (QRP)
  • External Transfer Form
  • Participant Application
  • Designation of Beneficiary
  • Privacy Statement
  • QRP Amendment Kit
  • QRP Basic Plan Document
  • Rates and Fees
  • Section 408(b)(2) Disclosure
  • Summary Cash Balance Form

During this process, it’s important to note that you will need to provide information. This includes personal details, your employer identification number (EIN), and more. At this time, you will also need to make decisions on your investments. This includes deciding which investment options like mutual funds you want to put your money towards. This part is important in making sure you understand how your plan works so be sure to ask any questions during this time! Once you review the disclosures and documents it will be time to open your account and you will be set!

Frequently Asked Questions

Understanding a Self Employed 401(k) can be confusing. That is why there may be questions you have that others have had as well!

What are Alternatives to a Solo 401(k)?

Besides a Solo 401(k) there are a variety of other retirement savings accounts that you can consider. Some alternatives are:

  • Traditional IRA
  • Roth IRA
  • SEP IRA
  • Investment Brokerage Accounts

Which Retirement Account is Better: a 401(k) or IRA?

The best retirement account will depend on your situation and goals. That is why the best way to confirm would be to get in touch with a professional. Professionals can take a look at your exact situation and let you know the best course of action for what you’re dealing with.

What is Self Employment Tax?

When you have a Self Employed 401(k) like a Solo 401(k), it is important to keep self employment tax in mind. That’s because when you are self employed, you are basically the employer and the employee. That means you will be responsible for the full 15.3% tax rate for Medicare taxes and Social Security taxes.

When is the Tax Filing Deadline?

The tax filing deadline was April 18th, 2022. However for 2023 it will fall on April 15th!

Is Your 401(k) Contribution Considered a Business Expense?

You will want to direct any tax questions you have to a professional. They will be able to help you understand what will be and won’t be considered a business expense!

Article References

https://www.investopedia.com/terms/1/401kplan.asp

https://www.investopedia.com/retirement/401k-contribution-limits/#toc-employer-contributions

https://www.fidelity.com/learning-center/personal-finance/retirement/self-employed-401k

https://www.nerdwallet.com/article/investing/what-is-a-solo-401k

https://www.trustetc.com/blog/solo-401k-pros-and-cons/

https://www.irafinancialgroup.com/learn-more/solo-401k/solo-401k-eligibility/

https://fitsmallbusiness.com/how-to-set-up-a-solo-401k/

https://www.annuity.org/retirement/401k/alternatives/

https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes

https://www.calendardate.com/tax_day_2023.htm

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