401(k)s are the most common type of defined contribution retirement plan, meaning employees define how much they want to contribute, and that amount is automatically deducted from payroll and placed into the account. Employers serve as the “plan sponsor,” even though administration of the plan is done by a financial institution.
Individual 401(k)s are not much different from traditional 401(k)s, except they are specifically designated for sole proprietors with no employees. However, spouses may contribute if they earn income from the business.
Individual 401(k)s come in a traditional and a Roth version, just like IRAs. With the traditional option, individuals save money on a pre-tax basis and it remains tax-deferred until withdrawn, at which point it is taxed. With the Roth option, individuals invest their money after taxes and the money grows tax-free, so it is not taxed upon withdrawal. Sole proprietors can split their contributions between both types of accounts.
Even people who do not make their entire income from self-employment can be eligible for individual 401(k)s, as long as you claim some self-employment income. For example, if you have a full-time job with a company and do some freelance consulting on the side, that side income qualifies you for an individual 401(k).
401(k) plans are a good option for people that aim to save large sums of money. They allow you to put money away as an employer and an employee, which makes it possible to contribute more than allowed by other plans. For example, as an employee, you can save up to $18,000 in 2016; as the employer, you can contribute an additional 25% of your salary, or up to $53,000 in 2016 as the “profit sharing contribution.” Individual 401(k) plans also allow participants over the age of fifty to make “catch-up contributions,” or additional salary deferrals of $6,000 in 2016.
Similar to other retirement plans, individual 401(k)s will levy a 10% penalty for withdrawing funds before you turn 59 and a half. There are exceptions to this rule, such as purchasing a first home, making payments to prevent eviction or foreclosure, higher education expenses, or costs from the onset of a sudden disability. Unlike SEP IRAs -- another retirement savings option for the self-employed -- solo 401(k)s allow for personal loans of up to $50,000 or 50% of the account’s value.
However, individual 401(k) plans are more difficult to set up than SEP IRAs. They involve more paperwork and many of the firms that help you set up these plans will charge setup and annual fees, depending on the level of service and size of the account. Fees vary widely, so it is important to do research.
If you decide that an individual 401(k) is right for you, there are a range of providers who can help you set one up. As opposed to corporate 401(k)s, which offer dozens of choices, individual 401(k)s will restrict your investments to one fund group.
Individual 401(k)s are just one of the multiple options available to help sole proprietors save for retirement. If you do not plan to hire any employees and you plan to save a substantial amount, an individual 401(k) may be the best choice for you.