What Is an Individual Plan for the Self-Employed?

An individual plan offers a specialized retirement savings vehicle for self-employed individuals and small business owners without common-law employees. These plans provide a way to save for retirement with significant tax advantages, mirroring benefits of larger employer-sponsored retirement plans. This article explores their structure, requirements, and management.

Understanding Individual Plans

An individual plan, commonly referred to as a solo 401(k) or one-participant 401(k), serves as a retirement savings option for business owners who do not have full-time employees other than themselves or their spouse. This plan allows self-employed individuals to contribute to their retirement in both an “employee” and “employer” capacity. It combines elements of a traditional 401(k) and an Individual Retirement Account (IRA), offering higher contribution limits than IRAs.

Eligibility and Establishment

Eligibility for an individual plan hinges on having self-employment income and typically no full-time employees. This includes sole proprietors, partners in a partnership, owners of a Limited Liability Company (LLC), or shareholders of a corporation, provided they are the sole employee or their only employee is their spouse. Part-time employees working fewer than 1,000 hours per year generally do not affect eligibility. However, long-term part-time employees working at least 500 hours annually for three consecutive years may require inclusion in the plan, which could impact the plan’s qualification as a “solo” 401(k).

Establishing an individual plan requires several steps to ensure compliance with Internal Revenue Service (IRS) regulations. First, a written plan document must be adopted; this can be a prototype plan provided by a financial institution or a custom plan. Next, a trust or custodial account must be opened to hold the plan’s assets. An Employer Identification Number (EIN) specific to the individual 401(k) plan is also necessary for tax reporting and account management, distinct from any business EIN.

Setting up the plan involves gathering specific information. This includes details about the business, such as its legal name and EIN, and the desired effective date of the plan. Personal identification information and bank account details for funding the plan’s investment account are also required. The initial preparation focuses on having all necessary information and documents in place to formally adopt the plan and open the associated investment account.

Contribution Mechanisms

Individual plans allow for contributions in two distinct capacities: as an employee and as an employer. This dual role enables significantly higher savings potential compared to other retirement vehicles for the self-employed. Employee contributions are known as elective deferrals, similar to those in a traditional 401(k). For 2025, individuals under age 50 can contribute up to $23,500.

Individuals aged 50 and over can make additional catch-up contributions. For 2025, this catch-up amount is $7,500, bringing the total employee contribution limit to $31,000 for those aged 50-59 or 64 and older. A higher catch-up contribution of $11,250 is available for those aged 60 to 63, allowing a total employee contribution of $34,750. These employee contributions are made from earned income and can be designated as either pre-tax (traditional) contributions, which reduce current taxable income, or Roth (after-tax) contributions, which allow for tax-free withdrawals in retirement.

In addition to employee contributions, the individual, acting as the employer, can make profit-sharing contributions to the plan. These employer contributions can be up to 25% of the self-employed individual’s compensation, which is generally net self-employment income. The maximum compensation that can be considered for contribution calculation is $350,000 for 2025.

The combined total of both employee and employer contributions to an individual plan is capped annually. For 2025, this aggregate limit is $70,000 for individuals under age 50. With catch-up contributions, the combined limit can reach $77,500 for those aged 50-59 or 64 and older, and $81,250 for individuals aged 60-63. Contributions made on a pre-tax basis offer immediate tax deductions, reducing the current year’s taxable income, while all contributions benefit from tax-deferred growth until distributions begin.

Ongoing Plan Management

Once an individual plan is established, ongoing management becomes the responsibility of the business owner, who acts as the plan administrator. This involves making investment choices within the plan. Individual plans offer a wide range of investment options, including stocks, bonds, mutual funds, Exchange Traded Funds (ETFs), and sometimes even alternative assets like real estate.

Administrative considerations include making annual decisions regarding contribution amounts, which can vary based on the business’s profitability and individual financial goals. Regular rebalancing of investments is also advisable to maintain a desired asset allocation. If the plan’s assets exceed $250,000, the plan administrator is required to file Form 5500-EZ with the IRS annually to report the plan’s financial status.

Individual plans also offer the flexibility to roll over funds from other qualified retirement accounts. Funds from previous employer-sponsored 401(k)s or traditional IRAs can be transferred into an individual plan. This direct rollover process allows for consolidation of retirement savings without incurring immediate taxes or penalties. These rollover amounts do not count towards the annual contribution limits.

Distributions and Withdrawals

Normal, penalty-free distributions from an individual plan typically begin after the account holder reaches age 59½. For traditional individual 401(k) accounts, these distributions are generally taxed as ordinary income. Qualified distributions from a Roth individual 401(k), however, are tax-free, provided the account has been held for at least five years and the owner is at least 59½.

Required Minimum Distributions (RMDs) mandate that account holders begin withdrawing funds from their traditional individual 401(k) accounts once they reach age 73. This ensures that tax-deferred savings are eventually taxed. Beginning in 2024, Roth individual 401(k) accounts are exempt from RMDs during the original owner’s lifetime, aligning them with Roth IRAs.

Withdrawals made before age 59½ are generally considered early distributions and are subject to a 10% early withdrawal penalty, in addition to being taxed as ordinary income. The IRS provides several exceptions to this penalty. These exceptions may include distributions due to total and permanent disability, certain unreimbursed medical expenses exceeding a percentage of adjusted gross income, qualified birth or adoption expenses, and distributions made as part of a series of substantially equal periodic payments.