What Is an Independent 401(k)?
An independent 401(k), or small business owner (SBO) 401(k), is a tax-advantaged retirement savings plan available to individual small business owners and their spouses. The plan is a variation of the typical 401(k) plan offered by many large employers. Since, in this case, the employer and the employee are one and the same, the contribution limits for the independent 401(k) are higher. Contributions made to the plan as an employer are also tax-deductible, which can save the sole proprietor a great deal in taxes.
The independent 401(k) is sometimes called a solo 401(k), an indie K, or a self-employed 401(k).
- An independent 401(k) is a qualified defined-contribution retirement plan established by small business owners and sole proprietors for themselves and their spouses.
- These plans have mostly the same rules, requirements, and contribution limits as any other 401(k) plan.
- The "Indie K" is often easier and less expensive to establish and maintain than SEP or Keogh plans for small businesses.
Understanding the Independent 401(k)
A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code. Workers can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions.
The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement.
As with standard 401(k) plans, catch-up contributions are allowed for those above age 50 who have indie 401(k)s, and the maximum for that catch-up is $6,500 in 2020 and 2021.
The independent 401(k) offers many of the same features as a Keogh plan or a SEP IRA, but it can be cheaper to establish and maintain, and loans are often allowed against it. The major drawback to the independent 401(k) is that no outside employees can be hired, or the window of eligibility for this type of account closes.
Eligibility Requirements for Independent 401(k)
A common misconception about the Independent 401(k) is that it can be used only by sole proprietors. In fact, the SBO 401(k) plan may be used by any small businesses, including corporations, limited liability companies (LLC), and partnerships. The only limitation is that the only eligible plan participants are the business owners and their spouses if they are employed by the business.
A person who works for one company (in which they have no ownership) and participates in its 401(k) can also establish an SBO 401(k) for a small business they run on the side, funding it with earnings from that venture. However, the aggregate annual contributions to both plans cannot collectively exceed the IRS-established maximums. If your business has non-owner employees who are eligible to participate in the plan, your business may not adopt the SBO 401(k) plan. Therefore, if you have non-owner employees, they must not meet the eligibility requirements you select for the plan, which must remain within the following limitations:
You may exclude employees who are under age 21.
You may exclude nonresident aliens who receive no U.S. income and those who receive benefits under a collective-bargaining agreement.
Years of Service
- For 401(k) Employee Elective-Deferral Contributions: You may require an employee to perform one year of service before becoming eligible to make elective deferral contributions.
- For Profit-Sharing Contributions: You may require an employee to perform up to two years of service in order to be eligible to receive profit-sharing contributions. However, most SBO 401(k) plans will limit this requirement to one year.
- For Plan Purposes: An employee is considered to have performed one year of service if they work at least 1,000 hours during the year. While you may generally choose to require fewer than 1,000 hours under a regular qualified plan, most SBO 401(k) plans include a hard-coded limit of 1,000 hours.
"Indie 401(k)" Versions
There are two versions of the individual 401(k) plan: a traditional version and a Roth version.
With the traditional version, your tax-deferred money is only taxed when money is withdrawn. In the Roth version, after-tax money is paid in, and no further taxes are due when it is withdrawn. You can use financial calculators to help determine the best option for you between the two versions of the individual 401(k) plan. It is also possible to opt for both and divide contributions between the two plans.
For the 2020 tax year, you can make a maximum combined contribution of $57,000 (in 2021 that amount goes up to $58,000) plus an extra $6,500 (remains the same in 2021) as a catch-up contribution if you are age 50 or older.
If your business is not incorporated, you can generally deduct contributions for yourself from your personal income. If your business is incorporated, the contributions can be counted as a business expense.