One of the primary advantages of being self-employed or having a business you own is that you have greater control over your future from a financial- and work-life balance perspective. However, more and more entrepreneurs are starting to realize that being self-employed also can provide them with a potent opportunity to boost their retirement savings.
- So long as you meet the eligibility requirements, you can start a business to open a Solo 401(k)
- The Solo 401(k) plan is the best retirement option for the self-employed
- Enjoy higher contributions limits, a loan feature, and the ability to invest in alternative assets, such as real estate.
401(k) Plan vs. Solo 401(k) Plan
A participant in an employer 401(k) plan can generally make a maximum employee deferral contribution of $20,500 or $27,000 if at least age 50. The employee deferral contributions can generally be made in pretax or Roth. In addition to employee deferrals, many 401(k) plans also offer a matching employer contribution that ranges between 3%-5%. Whereas, with a Solo 401(k) plan in 2022, the maximum plan contribution is $61,000 or $67,500 if at least age 50. Hence, you can now understand why so many retirement-savvy investors ask how they can potentially be eligible to set up a Solo 401(k) plan.
Who Can Set-Up a Solo 401(k) Plan?
To be eligible to establish a Solo 401(k) plan, a business must satisfy two eligibility requirements:
- The presence of self-employment activity.
- The absence of full-time employees.
The Presence of Self-Employment Activity
The first eligibility requirement for establishing a Solo 401(k) is that the adopting employer must be a business. The business can take any form. It can be a sole proprietorship, LLC, C Corporation, S corporation, partnership, etc. The key factor is not the entity type that has been used to establish the business, but whether the activity of the entity rises to the level of a trade or business.
The determination of whether an activity should be deemed a business is based on several factors. First, an activity is not required to be a certain size or even generate a profit. However, the activity that is conducted must rise to a level of a trade or business. The business must sell a good or service with the anticipation of profit.
Intent is an important factor. The intent of the operator of the venture must be able to generate revenues and ultimately profit. The business does not need to have revenues at the time when it adopts the Solo 401(k) plan, but the intent must be that the business will generate revenues.
For example, a child that sells some baseball cards online is likely not in business. On the other hand, an individual who creates a website for his business, seeks inventory to sell, and is actively trying to sell a good or service would be deemed a business.
Much of the determination of whether an activity rises to a level of a trade or business comes down to facts and circumstances. Although, in most cases, it is quite clear whether an activity is being treated as a hobby or business by the participant. One exception to this rule is real estate.
Real Estate Business
In general, a real estate investor that is self-employed can treat the business as passive or active. A real estate investor that wishes to treat his or her real estate activity as passive will use Schedule E on IRS Form 1040 to report the income, gains, or losses. Whereas, an individual seeking to treat his or her real estate business as an active business will use Schedule C on IRS form 1040. Hence, a sole proprietor or single member LLC real estate investor can elect to use Schedule C if they wish to treat the activity as a business. Electing the Schedule C over the Schedule E will generally subject the income to social security & FICA tax of approximately 15.3%.
In summary, other than real estate, it is generally not very difficult to determine if an activity should be treated as a business or a hobby.
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The Absence of Full-Time Employees.
A business that establishes a Solo 401(k) plan cannot have any non-owner full-time employees. A full-time employee is deemed an employee that works more than 1,000 during the year. ERISA, which is the body of law that covers 401(k) plans, treat the spouse of a business owner as a non-employee. In addition, the following types of employees may be generally excluded from coverage:
- Employees under 21 years of age
- Employees that work less than 1000 hours annually
- Union employees
- Nonresident alien employees
A business that uses independent contractors versus employees would be in a good position to establish a Solo 401(k) plan. The IRS defines an independent contractor as a work relationship where the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The IRS does not treat one as an independent contractor if one performs services that can be controlled by an employer (what will be done and how it will be done). This applies even if one is given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.
Essentially, any business that does not have any non-owner full-time employees will be able to establish a Solo 401(k) plan.
Solo 401(k) Plan Advantages
The following are the main reasons why the Solo 401(k) plan has become such a popular retirement plan:
- Maximize Retirement Savings & Deductions: Higher contribution limits allows for more savings and tax savings
- Self-Directed Investment Alternatives: Invest in almost anything you want including, real estate, precious metals, cryptos, private businesses, and, of course, stocks.
- Loan Feature: Borrow up to $50,000 or 50% of the 401(k) balance (whichever is less) to use for any purpose without tax or penalty./li>
- Control Investments – Serve as the trustee of the plan and get checkbook control over plan funds.
- Use Leverage for Real Estate Without Tax: Unlike an IRA, when you borrow money to purchase real estate, you are not subject to the UBTI tax.
Assuming you meet the eligibility requirement, anyone can start a new business and open a Solo 401(k). It’s time to take control of your retirement planning, instead of letting someone else decide what you are allowed to invest in. By gaining checkbook control of your 401(k) funds, you have an almost endless menu of investment choices.