Can You Have a 401(k) if You Are Self-Employed?
Explore how self-employed individuals can set up and manage a 401(k), including eligibility, contribution limits, and compliance considerations.
Saving for retirement is just as important for self-employed individuals as it is for traditional employees. Without an employer-sponsored 401(k), many independent workers assume they have fewer options, but that’s not the case. Specific 401(k) plans exist to help self-employed people build their retirement savings effectively.
Eligibility Criteria
Self-employed individuals can establish a 401(k) if they have self-employment income. Sole proprietors, independent contractors, and single-member LLCs qualify, as do partnerships and multi-member LLCs if each participant earns income from the business.
A solo 401(k) is ideal for business owners without full-time employees other than a spouse. If a business hires employees working at least 1,000 hours per year, it must comply with nondiscrimination rules under the Employee Retirement Income Security Act (ERISA), often requiring a transition to a traditional 401(k).
Only earned income—such as wages reported on a Schedule C or K-1—can be used for contributions. Passive income, like rental earnings or dividends, does not qualify. Business owners with multiple income streams must ensure that only self-employment earnings determine their contribution limits.
Plan Options
Self-employed individuals have several retirement savings options, each with different benefits. The solo 401(k) is popular due to its high contribution limits and flexibility. It allows both employer and employee contributions, increasing the total amount that can be saved. A Roth solo 401(k) permits after-tax contributions, leading to tax-free withdrawals in retirement.
A Simplified Employee Pension (SEP) IRA is another option, particularly for those seeking minimal administrative requirements. SEP IRAs allow contributions up to 25% of net earnings or $69,000 in 2024, but only employer contributions are permitted. Unlike a solo 401(k), there are no employee deferrals, which can limit total savings potential.
For those planning to hire employees, a SIMPLE 401(k) or SIMPLE IRA may be more suitable. These plans have lower contribution limits but require mandatory employer contributions. They also have fewer compliance requirements than a traditional 401(k). However, switching from a SIMPLE plan to another retirement vehicle must wait until the next calendar year.
Contribution Rules
Maximizing retirement savings requires understanding contribution limits and tax implications. In 2024, the employee deferral limit is $23,000, with an additional $7,500 catch-up contribution for those aged 50 and older. Employer contributions can be up to 25% of net earnings, bringing the total possible contribution to $69,000—or $76,500 with catch-up contributions.
A solo 401(k) allows pre-tax or after-tax (Roth) contributions. Pre-tax contributions reduce taxable income for the year, while Roth contributions grow tax-free and allow tax-free withdrawals in retirement. Choosing between these options depends on expected future income and tax bracket.
Self-employment taxes also affect contributions. Since net earnings are calculated after deducting half of the self-employment tax, this reduces the amount eligible for employer contributions. Over-contributing results in a 10% excise tax if not corrected by the tax filing deadline, including extensions.
Setting Up the Plan
Choosing the right financial institution is the first step in establishing a self-employed 401(k). Banks, brokerage firms, and retirement plan providers offer different investment options, administrative support, and fee structures. Some providers charge higher custodial fees or limit investment choices, which can impact long-term returns.
After selecting a provider, the IRS requires a formal written plan to be adopted by December 31 of the tax year for contributions to be made. This includes a plan adoption agreement and a trust document outlining plan management. The business must also obtain an Employer Identification Number (EIN), as personal Social Security numbers cannot be used for plan administration.
Ongoing compliance involves tracking contributions to avoid exceeding IRS limits. Since self-employment income fluctuates, reviewing earnings and adjusting contributions prevents overfunding and excise taxes. Plans with assets over $250,000 must file Form 5500-EZ annually. Failing to file can result in penalties of $250 per day, up to $150,000 per return.
Distribution Requirements
Withdrawing funds from a self-employed 401(k) follows IRS rules to ensure retirement savings are used appropriately. Traditional solo 401(k) accounts require required minimum distributions (RMDs) starting at age 73 under the SECURE 2.0 Act. The amount is based on the account balance and life expectancy, using IRS Uniform Lifetime Tables. Failing to take RMDs results in a 25% penalty, reduced to 10% if corrected within two years.
Roth solo 401(k)s no longer have RMDs as of 2024, allowing funds to remain in the account indefinitely. Withdrawals from Roth accounts are tax-free if the account has been open for at least five years and the account holder is 59½ or older.
Early withdrawals before age 59½ generally incur a 10% penalty plus regular income taxes. Exceptions include disability, medical expenses exceeding 7.5% of adjusted gross income, and first-time home purchases up to $10,000. Substantially equal periodic payments (SEPPs) allow penalty-free withdrawals but require consistent annual distributions based on life expectancy.
Penalties for Noncompliance
Failing to follow IRS regulations for a self-employed 401(k) can result in financial penalties and tax liabilities. Exceeding contribution limits triggers a 10% excise tax if excess funds are not withdrawn by the tax filing deadline. If not corrected, the excess amount remains taxable in the year contributed and is taxed again when withdrawn.
Failing to file Form 5500-EZ for plans exceeding $250,000 in assets results in penalties of $250 per day, up to $150,000 per return. The IRS offers penalty relief through the Delinquent Filer Voluntary Compliance Program (DFVCP), but proactive correction is required.
Improper distributions, such as early withdrawals without a qualifying exception, result in a 10% penalty plus regular income taxes. Missing the 60-day deadline for indirect rollovers also leads to taxation. Repeated reporting failures, discriminatory contribution practices, or improper loan administration can lead to plan disqualification, making all assets immediately taxable.