If you’re an architect who is self-employed or receives 1099 income as an independent contractor, you know that it’s up to you to establish a retirement plan. But do you understand the various approaches available to you, such as an individual 401(k) plan, and which may best suit you and your situation?
If you’ve done your homework, you likely know about simplified employee pensions (SEPs) and savings incentive match plans for employees (SIMPLE) IRA plans. These plans typically appeal to small business owners because they’re relatively straightforward and inexpensive to administer.
What you may not know is that in many cases an individual 401(k) plan, which is also known by other names such as a solo 401(k) plan, an employer-only 401(k) plan, a single participant 401(k) plan, or a mini 401(k) plan, may offer a better combination of benefits. An individual 401(k) plan is worth considering if you’re looking to set up your first retirement plan or want to switch to a different plan.
What is an individual 401(k) plan?
An individual 401(k) plan is a regular 401(k) plan combined with a profit-sharing plan. However, unlike a regular 401(k) plan, an individual 401(k) plan can be implemented only by self-employed individuals or small business owners who have no other full-time employees (an exception applies if your full-time employee is your spouse). If you have full-time employees age 21 or older (other than your spouse) or part-time employees who work more than 1,000 hours per year, you will typically have to include them in any plan you set up, so a safe harbor or traditional 40(k) would be a better option in that case.
An individual 401(k) plan isn’t really a different kind of 401(k) plan. Rather, it simply takes advantage of the fact that relaxed rules apply when the only individuals who participate in the plan are the owner and the owner’s spouse.
What makes an individual 401(k) plan attractive?
One feature that makes an individual 401(k) plan an attractive retirement savings vehicle is that, in most cases, your allowable contribution to an individual 401(k) plan will be as large or larger than you could make under another type of retirement plan. This will enable you to save more and be better prepared for retirement in the future.
With an individual 401(k) plan, you can elect to defer up to $19,500 of your compensation to the plan for 2021 (up from $19,000 in 2020), just as you can with any 401(k) plan. If you reach age 50 or older by the end of 2021, you can make an additional “catch-up” contribution of $6,500. In addition, as with a traditional profit-sharing plan, your business can make a maximum tax-deductible contribution to the plan of up to 25% of your compensation (or slightly less if you are a sole proprietor or unincorporated).
Because the amount of compensation deferred as part of a 401(k) plan does not count toward the 25% limit, you, as an owner-employee, can defer the maximum amount of compensation under the 401(k) plan, and still contribute up to 25% of total compensation to the profit-sharing plan on your own behalf. Total plan contributions for 2021 cannot, however, exceed the lesser of $58,000 or 100% of your compensation ($57,000 for 2020), plus any catch-up contributions if you’re 50 or older.
For example, Dan is a 35-year-old architect, the sole owner of his own firm, and his 2021 compensation is $80,000. Dan sets up an individual 401(k) plan for his retirement. Under current tax law, Dan’s plan account can accept a tax-deductible business contribution of $20,000 (25% of $80,000), plus a 401(k) elective deferral contribution of $19,500. As a result, total plan contributions on Dan’s behalf equals $39,500, which falls within Dan’s contribution limit of $58,000 (the lesser of $58,000 or 100% of compensation.
Individual Roth 401(k) plans
These contribution possibilities aren’t unique to individual 401(k) plans; any business establishing a regular 401(k) plan and a profit-sharing plan could make similar contributions. But individual 401(k) plans are simpler to administer than other types of retirement plans. Since they cover only a self-employed individual or business owner and his or her spouse, individual 401(k) plans are not subject to the often burdensome and complicated administrative rules and discrimination testing that are generally required for regular 401(k) and profit-sharing plans.
You can design your individual 401(k) plan to let you designate all or part of your elective deferrals as Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pre-tax contributions to a 401(k) plan, there’s no up-front tax benefit — contributions are transferred to the plan after taxes are calculated. Because taxes have already been paid on these amounts, a distribution of your Roth 401(k) contributions is always free from federal income tax. Plus, all earnings on your Roth 401(k) contributions are free from federal income tax if your distribution is “qualified.”
Other advantages of an individual 401(k) plan
Large potential annual contributions and straightforward administrative requirements are appealing, but individual 401(k) plans have other advantages, which are shared by many other types of retirement plans:
- An individual 401(k) is a tax-deferred retirement plan, so you pay no income tax on plan contributions or earnings (if any) until you withdraw money from the plan [qualified distributions from Roth 401(k) accounts are entirely free from federal income taxes]. Plus, your business’s contribution to the plan is tax deductible.
- Contributions to an individual 401(k) plan are completely discretionary. You should always try to contribute as much as possible, but you always have the option of reducing or even suspending plan contributions if necessary.
- An individual 401(k) plan can allow loans and may allow hardship withdrawals if necessary.
- An individual 401(k) plan can accept rollovers of funds from another retirement savings vehicle, such as an IRA, a SEP, or a previous employer’s 401(k) plan.
The AIA Trust is here to help
The AIA Trust offers retirement savings plans and distribution options through Equitable to assist you in achieving your retirement goals. Plans can be established for one-person firms (or components)—or for many employees—utilizing a variety of retirement savings and distribution vehicles. Equitable can assist you toward achieving your goals based on more than 51* years of experience working with association members and over 25 years with AIA architects. Equitable can help you review your options and offer you choices that can alleviate the burden of establishing and managing a retirement savings plan. It’s one of the ways that the AIA Trust makes it easier for you to focus on doing what you do best: architecture.
Please call (800) 523 1125 to speak with a retirement program specialist or learn how you can start saving.
All rights reserved. This article is prepared and published by Broadridge Investor Communication Solutions, Inc. Copyright 2020 to help keep you up to date on the issues that may affect your financial well-being.
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GE-3457741 (2/21) (Exp. 2/23)