Independent 401(k) Definition

What Is an Independent 401(k)?

The term independent 401(k) refers to a tax-advantaged retirement savings plan available to individual small business owners and their spouses. It is a variation of the 401(k) plan that many large employers offer their workers. Since it is a small business owner 401(k), the employer and employee are one and the same, which means that the retirement contribution limits are higher than traditional plans. The contributions made as an employer are tax-deductible, which can save the sole proprietor a great deal in taxes.

How Independent 401(k)s Work

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 Internal Revenue Code (IRC). Workers can make contributions to their 401(k) accounts through automatic payroll withholding and their employers can match some or all of those contributions—or none at all.

The independent 401(k) is a workplace retirement plan available to owner-only small businesses, including corporations, limited liability companies (LLC), and partnerships. The only other participants can be business owners' spouses, as long as they work for the company. Plans don't qualify if any outside or additional employees are hired. Independent 401(k)s are generally cheaper to establish and maintain, and participants are able to borrow against their balances.

Some of the same rules that apply to 401(k)s also apply to independent 401(k)s, such as:

• Excluding anyone under the age of 21.
• Completing at least one year of service by employees before becoming eligible for elective deferral contributions. An employee is considered to have performed one year of service if they work at least 1,000 hours during the year.
• The requirement that employees perform up to two years of service to be eligible for profit-sharing contributions, although most plans limit the requirement to a single year.

Contributions are also limited by the Internal Revenue Service (IRS) just like other retirement accounts. The agency allows individuals to put aside $20,500 in 2022 and $22,500 in 2023 in an individual 401(k). Those 50 and older can put away an additional catch-up contribution of $6,500 for 2022, increasing to $7,500 for 2023.

Special Considerations

A person who works for one company (in which they have no ownership) and participates in its 401(k) can also establish an independent 401(k) for a small business they run on the side. The independent 401(k) can be funded with earnings from the small business. But 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 independent 401(k) plan. Therefore, if you have non-owner employees, they must not meet the eligibility requirements you select for the plan.

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.

Types of Individual 401(k)s

There are two versions of the individual 401(k) plan—the traditional version and a Roth version. Tax-deferred money is only taxed when money is withdrawn in the traditional version. In the Roth version, you don't pay taxes on withdrawals during retirement because you set aside after-tax money. It is also possible to opt for both and divide contributions between the two plans.

You can make a maximum combined contribution of $61,000 in 2022 plus an extra $6,500 as a catch-up contribution if you are age 50 or older. That limit increases in 2023 to $66,000 plus an additional catch-up contribution of $7,500.