The Individual 401k is a 401k plan that is available to sole proprietorships. Sole proprietors are eligible for an Individual 401k provided they have no W-2 employees (other than a spouse) who work more than 1,000 hours per year. Partnerships who employ only the partners and have no W-2 employees who work more than 1,000 hours per calendar year are also eligible.
Individual 401k plans were developed due to the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that went into effect January 1st, 2002. The new law made several changes to the existing rules of 401k plans. These changes made the Individual 401k a very attractive retirement plan for sole proprietors.
Simply stated there are 2 primary advantages of the Individual 401k versus other sole proprietor retirement plans.
- Potentially greater retirement contributions at the same income level, therefore maximizing retirement contributions and valuable tax deductions.
- The option of a 401k loan up to a maximum of $50,000 using your 401k balance for the 401k loan.
2020 Individual 401k Calculations for a Sole Proprietorship
The maximum Individual 401k contribution limit in 2020 is $57,000 and $63,500 if age 50 or older. Because of the way the contribution is calculated a larger contribution usually can be made into an Individual 401k than to a Keogh, SEP IRA or SIMPLE IRA at the same income level. Only the Defined Benefit Plan can potentially allow a greater contribution than an Individual 401k, however a Defined Benefit Plan is much more expensive administratively and has mandatory annual funding requirements. As a result the Individual 401k is popular choice for sole proprietors who want the option of making a significant contribution and having the flexibility of completely discretionary contributions. A sole proprietor can increase, decrease or stop contributions to an Individual 401k each year.
The annual Individual 401k contribution consists of a salary deferral contribution and a profit sharing contribution. The total allowable contribution adds these 2 parts together to get to the maximum Individual 401k contribution limit.
Salary Deferral Contribution
Although the term salary deferral is used, a sole proprietor is not paid a W-2 salary. As a result, the salary deferral contribution is based on net adjusted business profit. Net adjusted business profit is calculated by taking gross self employment income and then subtracting business expenses and then 50% of the self employment tax. In 2020, 100% of net adjusted business profits income up to the maximum of $19,500 or $26,000 if age 50 or older can be contributed in salary deferrals to the Individual 401k.
Profit Sharing Contribution
A profit sharing contribution can be made up to 20% of net adjusted business profits. Net adjusted business profit is calculated by taking gross self employment income and then subtracting business expenses and then 50% of the self employment tax.
- EXAMPLE 1
A sole proprietor is age 35 and works as an independent contractor with $50,000 of net income in 2020. In this example, the sole proprietor could contribute $19,500 of salary deferrals + $9,294 profit sharing contribution = $28,794 Total Individual 401k contribution.
- EXAMPLE 2
A sole proprietor is age 35 and works as an independent contractor with $100,000 of net income in 2020. In this example, the sole proprietor could contribute $19,500 of salary deferrals + $18,587 profit sharing contribution = $38,087 Total Individual 401k contribution.
- EXAMPLE 3
A sole proprietor is age 50 and works as an independent contractor with $50,000 of net income in 2020. In this example, the sole proprietor could contribute $26,000 of salary deferrals + $9,294 profit sharing contribution = $35,294 Total Individual 401k contribution.
- EXAMPLE 4
A sole proprietor is age 50 and works as an independent contractor with $100,000 of net income in 2020. In this example, the sole proprietor could contribute $26,000 of salary deferrals + $18,587 profit sharing contribution = $44,587 Total Individual 401k contribution.
Salary deferral and profit sharing contributions are generally 100% tax deductible from personal income
Is there a deadline to make salary deferrals into the Individual 401k?
For a sole proprietorship the deadline for depositing salary deferrals into the Individual 401k is generally the personal tax filing deadline April 15 (or October 15 if an extension was filed).
When must profit sharing contributions be made into the Individual 401k?
For a sole proprietorship the deadline to fund the profit sharing contribution is the personal tax filing date of April 15 (or October 15 if an extension was filed).
Individual 401k Calculator
To determine the annual retirement contribution you could make based on your income use the Individual 401k Calculator.
Individual 401k Loan
Another advantage of the Individual 401k versus other sole proprietor retirement plans is the ability to receive a loan using the balance of the 401k for the loan. Individual 401k loans are permitted up to a maximum of $50,000. The proceeds from an Individual 401k loan can be used for any purpose, there are no income or credit qualifications to receive the loan and interest and principal are repaid to yourself. A 401k loan from an Individual 401k is received by the sole proprietor tax free and penalty free provided loan payments are paid on time.
IRS rules permit 401k loans, however not all Individual 401k providers allow loans. Provided there is a loan provision, then a 401k loan is permitted using the accumulated balance of the 401k for the loan. 401k loans are permitted up to 50% of the total balance of the 401k up to a maximum of $50,000. A 401k loan from the Individual 401k is received tax free and penalty free. There are no penalties or taxes due provided loan payments are paid on time.
Individual 401k loans are repaid either monthly or quarterly and typically a 401k loan has a 5 year term. An Individual 401k loan used for the purchase of a primary residence may have a 15 year term (the maximum loan term for a residence will vary depending on the provider). 401k loans must be repaid according to the terms of the loan amortization schedule which is provided when a loan is initiated.
Example: Bill is a 40 year old sole proprietor with no employees. Bill decides to open an Individual 401k to save for his retirement. After opening the Individual 401k he transfers $25,000 from his Rollover IRA, $25,000 from his SEP IRA, $25,000 from his Traditional IRA and $25,000 401k rollover from a 401k that he had still sitting in a former employer’s 401k plan.
After the four retirement accounts have been transferred into Bill’s Individual 401k he would have a $100,000 balance. He would qualify for a maximum 401k loan of $50,000. If Bill submitted a 401k loan request for $50,000 then he would receive a check for $50,000 for the loan and he would have a $50,000 balance remaining in his Individual 401k. The remaining $50,000 would continue to be invested and monthly loan payments would also be invested.
Note: An Individual 401k loan is not a debt instrument. The loan is not made by a bank or lending institution. With a 401k loan you are simply borrowing your own money from your 401k.
Can I rollover my other retirement plans into my Individual 401k and then take an Individual 401k loan?
Yes. You can rollover other retirement plans to an Individual 401k to consolidate your other retirement plans and quickly build the value of your Individual 401k. By rolling over your existing retirement plans into an Individual 401k you build the balance quickly in the Individual 401k and then use its value to receive a larger Individual 401k loan.
What retirement accounts can be transferred into an Individual 401k?
Retirement accounts that are permitted to be rolled over into an Individual 401k include a 401k, 403b or 457 plan from a previous employer, SEP IRA, Keogh plans (money purchase/profit sharing plan), defined benefit plans, Traditional IRA and Rollover IRA.
A Roth 401k from a previous employer may be eligible to be rolled over into an Individual Roth 401k provided the 401k plan document permits Roth 401k contributions and rollovers. IRS rules do not allow a Roth IRA to be rolled over into an Individual Roth 401k.
Is an Individual 401k loan tax free?
Yes. The Individual 401k loan is received tax free and penalty free. There are no penalties or taxes due provided loan payments are paid on time.
When does an Individual 401k loan need to be repaid?
In general an Individual 401k loan must be repaid in no longer than 5 years. If an Individual 401k loan is used for the purchase of a primary residence then a loan may be extended to as long as 15 years. Loans must be repaid according to the terms of the loan amortization schedule which is provided when a loan is initiated. Failure to repay the loan according to these terms may result in a loan default causing taxes as well as IRS penalties. However, payments of interest and principal on the loan are paid into your own Individual 401k.
Can I repay my Individual 401k before the term of the loan?
Yes. You can pay off the balance of the Individual 401k loan at any time without a pre-payment penalty.
When I receive an Individual 401k loan do I have to pay interest?
Yes. Loan payments are made monthly or quarterly and each loan payment will consist of principal and interest. Generally, the loan interest rate charged is the Prime Rate (3.25%) plus 1% or 2%. The interest rate depends on the 401k provider’s plan document. An Individual 401k loan is unique because the payments of principal and interest are paid back directly to your own Individual 401k plan.
Are there any credit checks or income qualifications to receive an Individual 401k loan?
No. There are no income or credit qualifications to receive an Individual 401k loan.
Why consider an Individual 401k loan as a small business loan?
Small business loans are often needed by small business owners, entrepreneurs and self employed individuals. Getting a small business loan through banks and lending institutions can be difficult. Potentially there is a simple solution. Many small business owners are getting loans up to $50,000 using an Individual 401k loan as a small business loan because 401k loans are fast, easy to obtain and have favorable interest rates.
What are the advantages of using an Individual 401k loan as a small business loan?
- The loan can be used for any purpose.
- Since you are using your Individual 401k's balance, you are automatically approved for the loan.
- There are no income or credit qualifications. As a result, bad credit won't prevent you from getting a 401k loan.
- Since you are borrowing your own money, principal and interest payments are paid back into your own 401k.
- 401k loan interest rates can be as low as the Prime rate (3.25%) plus 1% or 2%.
What are the disadvantages of an Individual 401k loan?
401k loans must be repaid according to the terms of the loan amortization schedule which is provided when a loan is initiated. Failure to repay the 401k loan according to these terms will result in a loan default. Income taxes would be due on the remaining unpaid balance of the loan and there is a 10% IRS penalty.
Also, by taking a 401k loan you are removing assets from your 401k. If your investments grow in value the outstanding loan balance will not experience that growth. As a result, you may not experience the same level of growth in your portfolio as compared to if you not taken a 401k loan and left all the money to grow in your 401k.
What is the process to secure a small business loan using the Individual 401k?
- Open an Individual 401k.
- Rollover/Transfer your retirement accounts - You can rollover your 401k, 403b, 457 retirement plan from a previous employer. You can transfer a Rollover IRA, Traditional IRA, SEP IRA, Simple IRA and Keogh plan.
- Submit 401k Loan Request Form - Once the retirement assets have been transferred into your Individual 401k for 5 business days, you are immediately eligible for a 401k loan.
What type of Individual 401k does BCM setup for clients?
If you search online you will find that several types of Individual 401k plans that are available. Some of these self directed 401k plans allow investors to invest in alternative investments like gold, tax liens and real estate. Some Individual 401k plans allow you to do complex transactions in which you can buy shares of stock in your business. These 401k plans are complex, very expensive (sometimes thousands of dollars to setup and have high annual maintenance fees) and may have potential complications with the IRS.
A simple alternative to these complex plans would be to set up an Individual 401k that uses mutual funds as the investment choice within the 401k. US corporations traditionally have had mutual funds as the investment vehicle within their 401k plan and 401k participants are usually familiar with this type of investment option. An Individual 401k that uses mutual funds as the investment option can be inexpensive administratively. BCM works with several Individual 401k providers, however the Individual 401k we recommend most frequently to our clients costs $0 to setup and $15 annual fee (the $15 fee is waived with a $50,000 balance). 401k loans are available and the cost for a 401k loan is a $50 application fee and an annual fee of $25. Through this 401k there are over 50 mutual funds to choose from ranging from conservative bond mutual funds to aggressive stock mutual funds to accommodate investors based on their age, time horizon and personal risk tolerance. Complete the form below and we would be happy to provide you with information about this Individual 401k.