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Solo 401 (k) Plans For Freelancers

Solo 401 (k) Plans For Freelancers

Freelancers often have much more freedom than their traditionally hired colleagues, but they also face unique challenges. One of the most important is the lack of an employer-sponsored retirement account.

When working as a self-employed, the task of saving enough is entirely up to you, but a Solo 401(k) plan can make that challenge a little easier. It is similar to a traditional 401 (k) plan but is designed specifically for the self-employed. Here's what you need to know about it.

What is a Solo 401(k)?

A Solo 401 (k), sometimes referred to as an individual 401 (k), is a retirement account created for self-employed professionals without full-time employees. There will be an exception if your spouse works for your business. If so, you can both contribute to a solo 401 (k) plan.

It works similar to a 401 (k) plan that can be offered to a traditional worker by hiring them, but since the self-employed act as employees and employers, they can contribute larger amounts each year.

Solo 401 (k) at a glance

  • Eligibility: Self-employed or small business owners with no employees 

  • Contribution Limit: $57,000 (2020) or $58,000 (2021). People over 50 can contribute $63,500 (2020) and $64,500 (2021). 

  • Taxes: Contributions are before tax unless you have a Roth Solo 401 (k), then contributions are after-tax

The advantages of a Solo 401 (k)

The biggest benefit of an individual 401(k) plan is the ability to choose the type of plan and investment options that best suit your needs. Traditionally employed workers are limited to what their company offers, which may not be the best for them. When you are the boss, you choose how you invest your funds. You can also decide which type of 401 (k) offers the best tax benefits.

Traditional vs. Roth

Solo 401(k) comes in two varieties: Traditional and Roth. Traditional solo 401(k) plans are tax-deferred. Make pre-tax dollar contributions and reduce your taxable income for that year. But then you have to pay taxes on your Solo 401(k) distributions during retirement. This is a smart move for those who believe they are making more money now than they would spend each year in retirement. Delaying taxes until your income drops will help you keep more hard-earned money.

Roth Solo 401 (k) works the other way around. This year you pay taxes on your contributions, but then the money grows without taxes. When you withdraw funds during retirement, you can keep it all to yourself - this is the best option for those who think they are earning about as much or less than what they plan to spend each year in retirement. If so, paying taxes now will cost you less than you expected.

In return for these tax benefits, the government generally does not allow you to withdraw your 401 (k) funds yourself until the age of 59½ unless you are using the money for a qualified exception, such as a purchase of your first home or a large medical expenses. However, you can only withdraw 401 (k) Roth contributions at any time, provided you have had an account for at least five years. On the other hand, withdrawing money without a qualifying reason before 59½, on the other hand, results in a 10% penalty for early withdrawal.

Contribution limits for a Solo 401 (k)

Self-employed people can contribute up to $57,000 to a Solo 401(k) in 2020 or $63,500 if they are over 50. These limits increase to $58,000 and $64,500, respectively, for 2021. This is much higher than traditional employees can contribute to 401(k) because the self-employed can also contribute as employers.

The employee's contribution is $19,500 for 2020 and 2021 or $26,000 if they are 50 years of age or older. This is the same amount that traditionally employed workers can contribute to 401(k) s.

The employer's contribution can be up to 25% of your net self-employment income, which is defined as all of your self-employment income minus business expenses, half of the self-employment tax, and money that you have contributed to your Solo 401(K) for your employees' contribution. For example, if you earned $100,000 in net income on your own, you can make an employer contribution of up to $25,000 to your individual 401 (k) plan.

Your maximum contribution is the lower of the annual contribution limit mentioned above or your employee's contribution plus 25% of your net self-employment income. Therefore, you cannot contribute more than $58,000 in 2021, even if your employer's contribution allows you to do so, and you cannot exceed the maximum employer and employee contribution for the year, even if you haven't hit the limit.

How to start a Solo 401 (k)

Follow the steps below if you want to open a Solo 401 (k).

  • Obtain an Employer Identification Number (EIN): An EIN is required to open a Solo 401 (k). You can apply for one on the IRS website.

  • Choose the broker: Explore the different brokers and see their investment offers, commissions, and customer service.

  • Complete the appropriate documentation: Your broker will send you an adoption agreement and a form to fill out before you can deposit money into your account.

  • Fund your account: You can fund your Solo 401 (k) plan by sending a check or using direct deposit to fund your account.

Once you've done these four things, you can start choosing your investments and making contributions to your account regularly. You can also transfer funds from other retirement accounts to your name if you wish.

You must pay your Solo 401(k) contributions by December 31. Still, you have until the tax filing deadline for the year, usually April 15 of the following year, to your employer's contribution for the year

One last thing you note is that if you have $250,000 or more in your Solo 401 (k) by the end of the year, you must send a 5500-EZ form to the IRS with your taxes so that you don't have a problem with the federal government.

A Solo 401 (k) plan isn't for everyone, but it's worth considering if you're independent. This will save you a lot more each year than an IRA and still get the same tax benefits.



Dennis Jao
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