Retirement plans are confusing enough. Understanding contribution limits, picking mutual funds and simply setting up your plan can be overwhelming. To complicate it further are the different types of plans from traditional IRAs to 401(k)s. Today, I’m going to highlight two plans that all self-employed folks should know about, the self-directed 401(k) and the Solo 401(k).
What is a Self-Directed 401(k)?
You may have heard of the self-directed IRA. Also, we have already discussed the self-directed 401(k) and its benefits. It’s an offshoot of the traditional 401(k) plan. In both, employees can fund their retirement with pre-taxed dollars which are automatically deducted from their paychecks. The only difference is that in a self-directed 401(k), employees act as their own funds manager with the ability to choose from a large list of investment options. However, these plans are employer sponsored. In fact, according to consulting firm Aon, since 2007, the amount of employers offering self-directed 401(k)s have increased by over 10%. Now where does this leave those who are self-employed? That’s where the Solo 401(k) comes in.
What is a Solo 401(k)?
The Solo 401(k) was established in 2001 with the passing of the Economic Growth and Tax Relief Reconciliation Act of 2001. It’s also known as the Solo 401(k), Solo-k, Uni-k and One-participant k. The Solo 401(k) is a type of self-directed 401(k) designed for self-employed individuals.
According to the IRS: “It’s a traditional 401(k) plan covering a business owner with no employees, or that person and his or her spouse (1).” Sole proprietorships, LLCs, partnerships, C-Corporations, S-Corporations also qualify under this plan. One must only claim self-employment income to qualify for a Solo 401(k). There are no exclusions for part-time self-employed individuals. However, any of business employees who work under 1,000 hours a year are excluded from the employee count.
Solo 401(k) Alternatives
This is not the first attempt at a retirement plan for self-employed individuals. The simplified employee pension or SEP, is another common plan for the self-employed. The main difference between the two plans are in contributions. In the Solo 401(k), there is an employee contribution and profit sharing option. Whereas in a SEP, there is only the profit sharing option. This difference is important because it’s possible to contribute more to your plan using a Solo 401(k) since you can contribute as both an employee and employer. Plus, the Solo 401(k) allows “catch up contributions” which can significantly increase your contribution limits if you’re over 50.
Self-Directed 401(k) Options
The Solo 401(k) offers the same benefits of an employer sponsored self-directed 401(k). However, with the Solo 401(k), business owners act as both employee and employer. Contributions are allowed under both classes, which can lead to increased contribution limits. Spouses can also make contributions, making the Solo 401(k) an ideal option for the self-employed and their family. If you’re self-employed, we can help you setup a retirement plan. Contact us for more information or to set up your consultation.