Self-Employed 401k Plan Advantages for Small Business Owners

A Self-Employed 401k Plan, also known as the Solo 401(k) Plan, is an IRS approved retirement plan. It is best suited for business owners who do not have any employees other than themselves and perhaps their spouse.

The Self-Employed 401k Plan (aka, One-Participant 401(k) Plan by the IRS) is not a new type of plan. It works like an employee-sponsored 401k plan. The major difference is, the Self-Employed 401(k) Plan covers only one employee (hence the name).

Self-Employed 401k Plan Contributions

A traditional IRA only allows an individual to contribute $6,000 annually, or $7,000 if over the age of 50. A Self-Employed 401k offers you the ability to contribute up to $62,000 each year.

Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) became effective in 2002, there was no compelling reason for an owner-only business to establish a Self-Employed 401k Plan. The business owner could typically receive the same benefits by adopting a profit sharing plan or a SEP IRA.

After 2002, EGTRRA paved the way for an owner-only business to put more money aside for retirement. Additionally, participants could operate a more cost-effective retirement plan than a Traditional IRA or 401k Plan.

There are a number of options that are specific to Self-Employed 401k Plans that make it a far more attractive retirement option for self-employed individuals than a Traditional IRA and other retirement plans, like the Self-Directed IRA.

Compare the Self-Employed 401k Plan to the Self-Directed IRA LLC. 

1. Reach your Maximum Contribution Amount Quicker

A Self-employed 401k plan includes an employee and profit sharing contribution option. Whereas a Traditional IRA has a very low annual contribution limit.

Under the 2019 Self-Employed 401k contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $19,000. You can make this amount in pre-tax or after-tax (Roth).

On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $56,000.

For plan participants over the age of 50, you can make a maximum employee deferral contribution in the amount of $25,000. Again, you can make that in pre-tax or after-tax (Roth).

On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $62,000.

Compare to a Traditional Self-Directed IRA

Whereas, a Traditional Self-Directed IRA only allows an individual with earned income during the year to contribute up to $6,00 (50 and under), or $7,000 (50 and over).

For example, Joe, who is 60 years old, owns 100% of an S Corporation with no full time employees. Joe earns $100,000 in self-employment W-2 wages for 2019. If Joe has a Self-Employed 401k Plan for 2019, he could defer approximately $50,000 for 2019. This is a $25,000 employee deferral, and 25% of his compensation which gives him $50,000 for the year.

However, if Joe establishes a Traditional Self-Directed IRA, he can only defer $7,000 for 2019.

2. No Roth Feature

A Self-Employed 401k plan has the pre-tax and after-tax (Roth) format. However, a traditional Self-Directed IRA only has the pre-tax format. In other words, you can only make pre-tax contributions.

Additionally, you can make a contribution of $19,000 ($25,000, if over the age of 50) to a Self-Employed 401k Roth account.

3. Tax-Free Loan Option

With a Self-Employed 401k, you can borrow up to $50,000 or 50% of your account value, whichever is less. You can use this loan for anything. However, you can’t borrow even $1 with a traditional Self-Directed IRA without triggering a prohibited transaction.

4. Use Nonrecourse Leverage and Pay No Tax

With a Self-employed 401k Plan, you can make real estate investments using non-recourse funds without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax.

However, the non-recourse leverage exception in IRC 514 is only applicable to 401k qualified retirement plans. It does not apply to IRAs. In other words, using a Self-Directed SEP IRA to make a real estate investment involving non-recourse financing would trigger the UBTI tax.

5. Open the Account at Any Local Bank

You can open a Self-Employed 401k Plan at any bank or trust company. But in the case of a traditional Self-Directed IRA, a special IRA custodian must hold the IRA funds.

6. No Need for the Cost of an LLC

With this plan, you can make real estate and other investments without the need of an LLC. Depending on the state of formation, an LLC could be very costly. Because a Self-Employed 401k is a trust, the trustee on behalf of the trust can take title to a real estate asset without needing an LLC.

7. Better Creditor Protection

Typically, the Self-Employed 401k offers greater creditor protection than a Traditional IRA. The 2005 Bankruptcy Act generally protects all 401(k) Plan assets from creditor attack in a bankruptcy proceeding. Additionally, most states offer greater creditor protection to a Self-Employed 401(k) qualified retirement plan than a Traditional Self-Directed IRA outside of bankruptcy.

This plan is unique and popular because it was designed explicitly for small, owner-only businesses. The many features of the plan is why self-employed and small business owners choose it over most retirement plans available.

Get in Touch

Do you have additional questions about the Self-Employed 401k plan that was not covered in this article? Contact IRA Financial today at 800-472-0646. Or fill out the form and speak with a 401k specialist.