Just because you’re self-employed, shouldn’t you get to save money for retirement tax-free just like all the rest of us working-stiffs?
The good news: You can! Out of all the financial savings plans out there, the individual 401k probably offers the best benefits because it was designed to look like the 401k plans offered to employees of large companies.
The IRS decided that sole proprietorships should not be left out of the benefits that come with a 401k plan. So, in 2002, the agency created the Economic Growth and Tax Relief Reconciliation Act that gives the self-employed and their spouses, similar retirement savings options as those enjoyed by others. So they get the chance to reach financial independence just like the rest of us!
What Makes the Individual 401k Unique?
The best thing about an individual 401k plan, which is also sometimes called a Solo 401k, a Single(k) or a Personal 401k, is that it allows self-employed individuals to make larger contributions than other kinds of individual retirement plans. This means that a Solo 401k can help people maximize their retirement savings and personal financial planning without raising their income levels.
For 2014, the contribution limits for a 401k are $51,000 for an individual under the age of 50 and $56,500 for people over 50. In contrast, the limits for an IRA are $5,500 for people under the age of 50 and $6,500 for people over 50.
This is a huge difference that can really help people sock away funds for their retirement. Even if you aren’t able to contribute the entire allowable amount, you still have the option of contributing more than what an IRA allows, thereby increasing your retirement funds for your golden years. You can use this calculator to determine how much you could save with an individual 401k.
In addition to higher contribution limits, Single 401k plans give you the flexibility of borrowing against the funds in your account if you need to support your business at any point between now and your retirement.
You are allowed to borrow up to 50 percent of the funds in your account to a maximum of $50,000. These loans are tax-free and as long as you pay your loan back in time, you will not have to pay taxes on the amount you borrowed until it is dispersed during retirement.
IRAs do not allow the account owner to borrow against the funds, so a Solo 401k is a more flexible option for business owners who will likely go through some lean years and need a loan to keep them afloat. While it isn’t recommended that you borrow against your 401k if you absolutely don’t need to, the option is there, which makes it a better choice for self-employed individuals.
Who Can Use This Self-Employed Retirement Tool?
As you might expect, there are limitations as to who can establish an individual 401k.
Since it is designed to support self-employed people or small businesses with no employees other than a spouse, only sole proprietorships, partnerships and corporations that meet these criteria can get Single 401k plans. To determine if you are eligible for this type of retirement plan, use the following criteria:
- You are self-employed as a sole proprietorship or as a corporation with no employees other than your spouse.
- You have W-2 employees that work fewer than 1,000 hours per year. You and your spouse are exempt from this limit.
- You use independent contractors who do not receive a W-2 at the end of the year. These employees usually receive a 1099 form instead.
There are some other types of employees you can exclude from your total to determine your eligibility for a Solo 401k. These are:
- Employees younger than 21 years old.
- Employees who have worked for you for less than a year.
- Some union employees.
- Some non-resident employees.
The Other Benefits of an Individual 401k:
While the clear benefit to a Personal 401k is the higher contribution limits, there are other benefits as well.
For example, you can choose whether you want to make your contributions before tax or after tax, which gives you the flexibility to decide how you want to handle the income taxes you will have to pay one way or the other.
In addition, not only is there a salary deferment component to these plans, there is a profit sharing component as well. The combination of these two types of contributions are added together to comprise the total contribution limit.
The salary deferment component is based on your net adjusted business profit, not what you claim on your W-2 form as salary. To calculate this, you take your gross self-employment income and subtract from it your business expenses and half of the self-employment tax. You are able to contribute 100 percent of your business profits up to $17,500 if you are under the age of 50. That limit is $23,000 if you are older than 50.
The profit sharing component is up to 20 percent of the net adjusted business profits, giving you the opportunity to contribute up to the maximum allowance of $51,000 or $56,500, depending on your age. If you are an S or C corporation or an LLC that is taxed as a corporation, the percentage of the profit sharing component increases to 25 percent of your W-2 earnings. The nicest part about this type of contribution is that you can decide to fund it or not based on the profitability of your company. You can also decide to fund it less or more than the previous year as long as you don’t go over the cap.
If you decide to make your contributions on an after-tax basis, be aware that only your salary deferral contributions are taxed based on tax calculators and estimators. The profit sharing component can only be made on a pre-tax basis and will therefore be taxed when you start taking distributions after you retire. This could be important if you are counting on paying all of your taxes now and living tax-free in retirement.
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