401k Options For Self Employed - When it comes to retirement plans for people who (1) have income from self-employment, and (2) don't have full-time W-2 employees who work more than 1,000 hours a year, many think that a SEP IRA is their best and/or only option. This does not have to be true.
Although it does not allow for a maximum contribution limit, ($57,000 for 2020, ) as a way to defer income taxes until retirement, and the ability to invest in traditional investments, that is all it offers.
401k Options For Self Employed
The Solo Self-Directed 401(k) starts with those features, but goes beyond that to offer several other benefits.
Solo 401k: My Favorite Retirement Plan For The Self Employed
When a business owner or independent 1099 contractor contributes to a SEP IRA, they do so through what is known as a Profit Sharing contribution. The amount allowed is based on how they are taxed.
They can contribute up to 20 percent of their net income from self-employment if formed as an LLC, Partnership or Sole Proprietorship. They can contribute up to 25 percent of their wages from self-employment if they are set up as an S-Corporation or C-Corporation. However, the amount contributed cannot exceed the annual limit of $57,000.
SEP IRA contribution example: Olivia will make $100,000 in net income (after deductions and less than ½ self-employment tax) from her one-person Etsy business set up as an LLC in 2020. The SEP IRA will allow her to contribute. to $20,000 ($100,000 * 20%) in 2020 bringing his taxable income to $80,000.
A Self-Directed Solo 401(k), on the other hand, allows making an Elective Salary Deferral contribution along with a Profit Sharing contribution. The amount that can be contributed as salary deferral is up to 100 percent of net income from self-employment not exceeding the 2020 annual limit of $19,500 for people under 50.
For 2021, 401(k) Contribution Limit Unchanged For Employees, Up For Employers
People aged 50 and over can make a salary deferral contribution of an additional $6,500, bringing their 2020 limit to $26,000. The profit-sharing contribution calculation is the same for a Self-Directed Solo 401. ( k ) as in the case of a SEP IRA.
The combined limit for both types of contribution cannot exceed $57,000 for those under 50, or $63,500 for those 50 and over.
Example of a Solo Self-Directed 401(k) contribution: Olivia can contribute $20,000 as a benefit distribution, as shown in the SEP IRA example above, but now she can also add $19,500 as salary deferral, bringing her contribution together. limit to $39,500 and her taxable income to $60,500. If Olivia were 50 or older, she could also include the $6,500 gain for a total contribution of $46,000, reducing her taxable income to $54,000.
Since both plans have the same annual limit of $57,000, it's important to understand the break-even income level—even when a 20 or 25 percent profit-sharing contribution equals $57,000 and the salary deferral increase is not now helping to increase the contribution amount.
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For 2020, the net income for Sole Proprietors, Partnerships and LLCs is $285,000, and for S-Corporations and C-Corporations the breakeven salary is $228,000. However, if the person is aged 50 or over, the catch-up contribution portion of the salary deferral will increase the limit to $63,500. Therefore, for anyone in this age group, a Self-Directed Solo 401(k) is better from a contribution limit standpoint.
2: Solo Self-Directed 401(k)s Allow loans to be taken out, (if the plan is designed to include the provision of loans.)
No IRA retirement plan allows taking out loans against the account. Self-Directed Solo 401(k)s allow loans of up to $50,000 or 50 percent of the account balance, whichever is less, tax-free and penalty-free, for any reason without limitation. They must be repaid, usually within five years, but if used to buy a main residence, they have 15 years to repay.
Payments must be made no less than quarterly; any unpaid amount of the loan, (after the expiration date, ) will be considered a distribution, and any applicable taxes and penalties will be owed by the account holder.
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Interest is charged on the loan, usually 1 per cent, but the interest goes back into the account and is added to retirement funds, rather than going to the financial institution, which would be the case with regular bank loan.
SEP IRAs generally require a custodian, such as a financial institution, to hold and direct the money to be invested in the products they sell, such as stocks, mutual funds, etc. This prevents the account holder from becoming a guarantor and restricting it. the ability to differentiate by asset class. It also increases the cost of managing the account.
Solo Self-Directed 401(k)s allow the account holder to be the trustee and do not require a custodian, which helps reduce the cost involved. They are free to direct money to invest in almost any asset class, including, but not limited to: residential and commercial real estate; tax bonds, documents, and restrictions; stock market, money, bonds, futures and options; many types of business; personal loans and hard money; land; oil and gas mineral rights; choose precious metals and some coins. Prohibited Transactions and Prohibited Persons Rules apply and must be followed when undertaking any investment transactions.
There are very few assets that the account cannot invest/own. They include S-Corporations because a self-directed Solo 401(k) cannot be a business shareholder. Nor can he invest in art, or collectables, such as stamps and baseball cards. Some may argue that Self-Directed Solo 401(k)s can own life insurance contracts, but most think that's pointless, so it's included here.
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4: Solo Self-Directed 401(k)s Allow maximum tax-free cash contributions during retirement, (if the plan is designed for it.)
Contributions to SEP IRAs can only be made through pre-tax profit sharing contributions. This is great for tax deferral purposes, but if the goal is tax-free money in retirement, the Solo Self-Directed 401(k) is the better option because it allows for Elective Roth contributions and After Tax.
First, a portion of salary deferral (up to $19,500) can be contributed after tax to a designated Roth account. If the account owner isn't particularly concerned about tax savings by withholding today and wants to increase his tax-free money in retirement, here's a way to add it: The account owner can make a tax-deferred Roth salary-advance contribution . profit sharing contribution.
They can then convert the profit sharing contribution into a Roth account and pay taxes. The account holder can then invest all the money through their Roth account so that the basis, profit and income from the investment(s) are all tax-free upon withdrawal.
Self Employed? A Solo 401(k) Might Be A Good Option For You
Secondly, 100 per cent of net income from self-employment, (up to an annual limit), can be contributed through a voluntary contribution after tax. Since the earnings and earnings on after-tax contributions are taxed when you withdraw them, the account holder will immediately convert the money into a Roth account. This method of contributing discretionary after-tax funds and then converting them to a Roth account is often referred to as a Mega Backdoor Roth.
Contributing after-tax dollars is also a way to reach, and increase, the contribution limit amount of $57,000, or $63,500, as it can be made in addition to salary deferral and profit sharing contributions. For example, look at Olivia's Solo Self-Directed 401(k) situation again, and assume she is under 50. Olivia was only able to contribute $39,500 due to her income level. If he wants to increase the full contribution amount, he can add $17,500 in after-tax dollars to reach the $57,000 limit.
Not all account holders can shave off a large portion of their income or net pay to maximize their retirement contribution, but a Self-Directed Solo 401(k) gives them the ability, and the choice, to contribute more. than the SEP IRA only allows the profit sharing limit, if they wish, and depending on their overall financial situation. Having a higher contribution limit can make a big difference to a business owner's tax liability and potentially bring them into a lower tax bracket.
The increased terms, flexibility, and personal direction that a Self-Directed 401(k) Plan offers are like hot fudge, whipped cream, syringes, and the cherry on top of a plain vanilla SEP IRA.
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For any eligible individual looking to maximize their contribution options, and tax efficiency today and/or in retirement while having direct control over a diversified and specialized investment portfolio, this option checks more boxes than SEP IRA .
Looking for more information about a self-directed Solo 401(k)? Be sure to check out my course on Udemy that covers everything you need to know to take advantage of this financial product. Solo Self-Directed 401(k).
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