What Is an Individual 401k Plan?

If you are self-employed or own a small business, you have probably considered establishing a retirement plan for yourself. You may know about simplified employee pensions (SEPs) and savings incentive match plans for employees (SIMPLE) IRA plans.

These plans are attractive to small business owners because they’re typically easy and inexpensive to administer. However, it would help if you also considered an individual 401k plan, which may offer you the best array of benefits.

In this article, we'll explore some of the ways an individual 401k plan can help you save for retirement without sacrificing you small business goals.

What Is an Individual 401k Plan?

An individual 401k plan is a regular 401k plan combined with a profit-sharing plan. These plans can only be used by solopreneurs or those who have a small business with no employees (with one exception being if the other full-time employee is your spouse). It can also go by the names solo 401k, solo-k, uni-k, or one-participant 401k. 

These plans are similar to larger companies’ plans, except that you get to contribute as both the employee and the employer. This means you have a higher contribution limit than many other tax-advantaged plans.

An individual 401k is perfect for those who want to contribute large sums to their retirement plan. In a traditional 401k offered at larger companies, you, as the employee, would make investments as a pretax payroll deduction from your paycheck. Your employer would have the option to match those employee contributions up to a certain amount. 

You get a tax break for your contributions, and your employer gets a tax break for its match. With an individual 401k plan, you contribute as both the employed individual and the employer, greatly increasing your contribution limits and tax break opportunities.

Tax Benefits with an Individual 401k

There is some flexibility in how you pay taxes with an individual 401k. First off, all the contributions that you make as an employer are tax-deductible for your business.

For the contributions you make as an employee, you have two options. If you go the traditional route, you will reduce your taxable income for the current year and grow tax-free until you reach retirement age. Once you take distributions from your retirement account, though, they will be taxed as regular income. 

If you opt for a Roth solo 401k, you do not get that upfront tax break; come retirement age, though, you will enjoy your distributions tax-free. Talk to your financial advisor to decide which plan is right for you.

Types of Contributions for a Solo 401k

There are two types of individual 401k contributions. The first is an elective deferral. In 2020, this option allowed individuals under the age of 50 to contribute up to $19,500. Those 50 and older were allowed to contribute up to $26,000.

The second type is profit sharing. With this type of contribution, your contribution is based on a percentage of income. In 2020, with this option, you could contribute up to $37,500, regardless of age.

Say Bill is the 45-year-old sole owner of an incorporated business. In 2020, his compensation is $85,000. Under the current law, he can make a tax-deductible contribution of $21,250 (25% of this year’s income) plus a 401k elective deferral of $19,500. As a result, Bill’s total contributions for the year can reach $40,750. 

These types of contributions could be made by any business that establishes a regular 401k and profit-sharing plan. That said, individual 401ks are much simpler to administer because they aren’t subject to complex administrative rules and burdensome testing in the way that regular 401k and profit-sharing plans are.

Contributions for an individual 401k plan are always completely discretionary - it is up to you how much or how little you contribute. Of course, you should always try to contribute as much as possible, especially because this plan allows you to contribute more than a traditional 401k. Just remember that you can always reduce or even suspend contributions if your financial situation changes.

Potential Disadvantages

Like any other 401k plan, you are subject to a 10% penalty fee on any withdrawals you make before the age of 59-and-a-half. Because these plans can only be used for yourself as a solo entrepreneur - and your spouse if applicable - using this type of plan can make things complicated if your business grows and you hire more full-time employees.

You will then need to have a regular 401k and profit-sharing plan. You will also have to let go of the benefits of the individual 401k plan’s simplified administration rules. This is why it's important to have a plan in place and not be caught by surprise when your business begins to scale.

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Setting up Your 401k

There is no filing required until the assets reach $250,000, but there is some paperwork required. To establish an individual 401k, you must work with a financial institution. Each institution may have different fees and limits regarding what investment options are available in the plan.

Typically, the set-up expenses will be higher the more advice and assistance if offered. Be sure to shop around and do your research to find the best fit for you.

And before you get started, consider visit the IRS Retirement Plans website. There you will find a full set of resources - including information about SEPs and other IRA plans - to help you start your retirement process.

401ks for Solopreneurs

Being a small business owner or entrepreneur does not mean you are stuck without retirement options. That said, it is important that you know your options and research the individual 401k plan that is right for you.

Talk to your financial advisor or other sole proprietors to learn how best to start the process. With a little research - and a few smart investments - you won't have to choose between long-term financial security and being your own boss.