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What is a self-employed 401(k) plan?

A self-employed 401(k) plan is a type of retirement account for business owners with no other employees.

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Most workers are at the discretion of their employer when it comes to retirement accounts. But when you’re self-employed, you have control. You can choose which retirement accounts are right for your goals – and how to best use them.

There are several accounts you can choose from, including one Individual 401(k). These are similar to a 401(k) you can get in a salaried position, although they allow you to save significantly more annually.

You can now explore your retirement options, including IRAs, by reviewing the top providers online.

What is a self-employed 401(k) plan?

Are you self-employed? Here’s what you need to know about individual 401(k)s and how to open one.

A self-employed 401(k) plan — also called a one-participant 401(k), individual 401(k) or solo 401(k) — is a type of retirement account for business owners with no other employees. They are designed for use by a self-employed professional and, if applicable, their spouse only

With a single 401(k), a self-employed person is considered both an employer and an employee. This means they can contribute to the account as both parties.

Currently, the IRS limits annual self-employed 401(k) contributions to:

  • For employees: Up to $20,500 (if you’re under 50) or $27,000 (if 50 or older)
  • For employers: Up to 25% of the employee’s total compensation. This is your net earnings minus half of your self-employment tax and the contribution you made to your 401(k) as an employee.
  • Total between both sides: $61,000 ($67,500 for those 50 and older)

Note that the IRS reevaluates its contribution limits annually, so these thresholds may change.

Alternative options

The two most common alternatives to a single 401(k) are SEP-IRAs and Simple IRAs.

  • SEP IRA (Simplified Employee Pension): This allows you to contribute up to $61,000 for 2022. All contributions are tax-deductible, and your account balance will remain tax-free until you retire. You only pay tax when you withdraw money online.
  • SIMPLE IRA (Savings Incentive Match Plan for Employees): These have much lower contribution limits. They let you save up to $14,000 of your net income ($17,000 if you’re 50 or older), plus a 2% defined contribution or 3% matching contribution as an “employer.”

You can now easily review your IRA options online.

Pros and cons of self-employed 401(k)s

Individual 401(k)s have many advantages.

  • Upper Contribution Limit: They have a high contribution limit, which allows you to build retirement savings fairly quickly.
  • Duty Free: They are tax-deductible and are funded using pre-tax earnings, meaning you don’t have to pay taxes on the money until you withdraw it later. This can be beneficial if you hope to be in a lower tax bracket in retirement.

However, there are also some downsides:

  • Age Limit: You must be at least 59 ½ to start withdrawing money, or you may face a 10% early withdrawal penalty.
  • It does not cover your employees: You can’t use a self-employed 401(k) to cover employees, so it might not be the best choice if you think you might expand your business in the future.

How to set up your self-employed 401(k) plan

To set up an individual 401(k) plan, you must first have an employer identification number. You can get this one by Apply online through the IRS.

Once you have an EIN, you simply choose your brokerage, fill out their required application form, and fund your account. Then you can choose investments and start building your retirement savings.

If you’re not sure if this self-employed retirement plan is best for you, talk to a financial advisor or tax preparer. They can help you choose the best account for your goals and business.

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