A 401(k) is a deferred tax saving plan where the employees of an organization/business save a part of their salary in 401(k) funds, for which she/he will not be required to pay taxes until the age of retirement. Here, both the employer and the employee will be allowed to make contributions into the fund. An individual 401(k) plan covers only the business owners, partners and their spouses thus freeing them from the complexities of the ERISA rules. They receive similar tax benefits as the general 401(k) plan, but without the involvement of the employer as compared to general 401k plans. It is specifically designed for businesses without full-time employees, and is for a self-owned or a self-employed business. Hence, it is also called Solo 401(k) plan or Self-employed 401(k) or one-participant 401(k) plan.
The contributions under this plan are similar to a general 401(k) plan where the profit sharing contribution is made by both the employer and the employee. Different contribution caps are available for different types of businesses. But, since in most cases, both the employer and the employee are the same, the contribution can be slightly higher. Also, provisions are available for additional contributions for plan holders who are above 50 years of age.
Basic qualification for an individual 401(k)
- An individual claiming to qualify for this plan must have some self-employed income either part-time or full-time.
- This plan can be claimed by an individual from any type of business- single owner, self-employed, partnership, company with limited liability, corporations etc. where she/he should have at least 5% share in the business.
- The business claiming this plan must not employ anyone full-time who is eligible to participate in Solo 401(k) (Except those employees who are below 21 years of age, expats and union members with certain benefit plans). Only the owner/partners and their spouses can claim under this plan.
Types of individual 401(k) plans
These are classified based on the documents and the agreement that states and controls the operations of the plan. The employer can customize the plan agreement according to the options available in the basic plan offered by a plan sponsor. A plan sponsor is a company that offers a plan to the employer, either as an individual designed plan or a prototype plan. There are two types of solo 401(k) plans where an investor can select a plan based on her/his investment goals, asset preferences, fee schedules and the level of control desired.
- Brokerage based 401(k) – The available investment options under this plan are limited, and offers market based assets like stocks and mutual funds. This plan does not allow loans of any kind.
- Self-directed 401(k) – This plan provides more investment options and allows for alternative assets like investment in real estate, private business, precious metals, personal loans and all other options offered by a Roth deferral However, collectibles are not allowed under this plan. This also allows for conversion of general 401(k) accounts to a Roth sub-account.