401k Options for the 1099 Employee

Independent contractors and other self-employed individuals operate without an employer-sponsored retirement plan. The term “1099 employee” reflects a common uncertainty about retirement savings for those who work for themselves. While a traditional 401(k) is a feature of standard employment, a set of alternatives exists specifically for the self-employed. These plans allow for tax-advantaged savings and can offer contribution limits that surpass those of conventional workplace plans.

Retirement Plan Options for the Self-Employed

Solo 401(k)

A Solo 401(k), known as a one-participant 401(k), is designed for a self-employed individual or a business owner with no employees other than a spouse. Hiring a full-time, non-spouse employee requires transitioning to a different type of 401(k) plan. Its defining feature is that the owner acts as both the “employee” and the “employer,” allowing for contributions in both capacities, which is a primary advantage.

A feature of many Solo 401(k) plans is the option to make Roth contributions with the employee portion of the savings. These post-tax contributions allow for tax-free withdrawals in retirement. Another differentiator is the potential for a participant loan. Depending on the plan document, you may be able to borrow against your account balance, a feature not available with other self-employed retirement plans.

SEP IRA

The Simplified Employee Pension (SEP) IRA is a popular retirement plan for self-employed individuals. Unlike the Solo 401(k), contributions to a SEP IRA are made solely by the “employer” to a traditional IRA established for the “employee.” This means there is no employee contribution component, and all savings are made on a pre-tax basis, providing a current-year tax deduction.

Eligibility for a SEP IRA requires an individual to have self-employment income. While these plans can be used by businesses with employees, the rules require that any contributions made for the owner must also be made for all eligible employees at the same percentage of compensation. This can become a significant expense for businesses with a workforce. The administrative burden is low, with no annual IRS filing requirements for the one-person business.

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a retirement plan for small businesses with 100 or fewer employees. For the self-employed individual, you act as both the employee and the employer, allowing for employee contributions while requiring an employer contribution. This plan is less flexible than a SEP IRA, where employer contributions are discretionary. A SIMPLE IRA must be established between January 1 and October 1 for the current tax year.

Contribution Rules and Limits

Solo 401(k) Contributions

The Solo 401(k) allows for two types of contributions. As the “employee,” you can contribute 100% of your compensation up to the annual deferral limit of $23,500, plus a $7,500 catch-up contribution if you are age 50 or over. As the “employer,” you can make a profit-sharing contribution of up to 25% of your net adjusted self-employment income. The total combined contributions cannot exceed $70,000. For example, a 40-year-old with $100,000 in net adjusted self-employment income could contribute $23,500 as an employee and $25,000 as the employer, for a total of $48,500.

SEP IRA Contributions

Contributions to a SEP IRA are made by the employer and are limited to 25% of your net adjusted self-employment income, up to a maximum of $70,000. This calculation is based on your gross self-employment earnings minus one-half of your self-employment taxes and the SEP contribution itself. Unlike the Solo 401(k), there are no employee contributions or catch-up contributions. Contributions are discretionary, so you can choose how much to contribute each year.

SIMPLE IRA Contributions

As the “employee,” you can contribute up to $16,500, plus a $3,500 catch-up contribution if you are age 50 or older. The employer contribution is mandatory and must be structured in one of two ways. The first is a dollar-for-dollar matching contribution up to 3% of your compensation. The second is a fixed non-elective contribution of 2% of your compensation. For example, with $80,000 in income, you could contribute $16,500 as an employee and be required to contribute an additional $2,400 as a 3% match.

Choosing the Right Plan for Your Business

If your primary objective is to save the maximum amount possible, the Solo 401(k) often stands out. Its dual-contribution structure allows individuals to potentially save more than they could in a SEP IRA, especially if their income is below the level needed to hit the overall maximum with a 25% contribution. The availability of a Roth option and participant loans enhances its flexibility.

For those who prioritize simplicity and low administrative effort, the SEP IRA is a compelling option. It involves a straightforward calculation and does not have the dual-contribution tracking of a Solo 401(k). There are no annual filing requirements for a one-person business, making it easy to maintain. A SEP IRA is well-suited for an individual who wants to make significant, discretionary contributions without the complexity of loan provisions.

The SIMPLE IRA is designed for business owners who may anticipate hiring employees or who have a more modest savings goal. Its contribution limits are lower than those of the Solo 401(k) and SEP IRA, but it provides a structured way to save that can be easily extended to employees. The mandatory employer contribution is a predictable part of the plan’s design.

Establishing and Funding Your Account

To open a retirement account for your business, you will need an Employer Identification Number (EIN), which you can obtain for free from the IRS. An EIN is required to establish a Solo 401(k) and is good practice for other business retirement plans. You will also need to complete a plan adoption agreement, which is the formal document that establishes the plan and is provided by financial institutions.

You will submit the completed adoption agreement to your chosen brokerage firm. Be aware of deadlines. A Solo 401(k) must be established by December 31 of the tax year. A SIMPLE IRA must be established between January 1 and October 1. For both Solo 401(k)s and SEP IRAs, contributions can be made up until your tax filing deadline, including extensions.

Once the account is open, you can link a bank account to initiate an electronic funds transfer, write a check, or wire money. When making the contribution, you will need to specify the tax year it is for. In the case of a Solo 401(k), you must also designate the amounts for the employee and employer portions of the contribution.