If you’re forming a business, it's a chance to start a new self-employed 401(k) or other small business 401(k) or retirement savings account. As an entrepreneur, you have several options for how to save for retirement in a tax-advantaged way. Even without the employer match of your old 401(k) or other employer-sponsored retirement plan, small business owners have options for how to set up a self-employed 401(k) type of plan.
Your new retirement account as a self-employed person might not be called a “401(k),” but you have several options to set up a tax-advantaged retirement plan. As an entrepreneur, you can still save and invest for retirement, potentially save money on taxes and set yourself up for a more secure financial future.
Learn more about small business 401(k) options.
What to Do with Your Old Job’s 401(k)
If you’re leaving a job, hopefully you already have some money saved for retirement with your old employer. You might be tempted to pull this money out of your 401(k) and use it to fund your new business.
BEWARE: if you take money out of your 401(k), you might have to pay a penalty for early withdrawal, pay income tax on the money you withdraw and potentially lose money on your long-term investment performance because you sold stocks prematurely.
If you have a 401(k) from your old job, you can either leave it alone in your old company’s investment plan or you can “roll over” the money into a Rollover IRA with a new investment management company. Setting up a Rollover IRA will not cause you to have any tax consequences; it is not a taxable event. With a Rollover IRA, you’re not withdrawing money from your retirement savings, you are just moving your retirement savings from one account to another.
So ideally: when you start your business, you should leave your old retirement account in “retirement savings.” Leave the money alone, and let it grow.
What Are Your Options for a New Small Business 401(k)?
You have several options for self-employed retirement savings and small business 401(k) plans, but it depends on whether you will have employees, how many employees you'll have, how much administrative work you’re willing to do and other factors. The IRS has a convenient guide called "Choosing a Retirement Solution for Your Small Business," which outlines the retirement plans this way:
- Payroll Deduction IRA: Employees can make a maximum annual contribution of $6,000 for 2020; you can contribute an additional $1,000 as a “catch-up contribution” if you are age 50 or over.
- Simplified Employee Pension (SEP) IRA: Employers can contribute up to 25 percent of an employee’s compensation, up to $57,000 for 2020. The SEP IRA is usually the easiest to set up and maintain, while also giving business owners flexibility to contribute a lot of money to their retirement savings.
- SIMPLE IRA: Employees can contribute up to $13,500 in 2020, and employees age 50 or over can make additional contributions of $3,000 in 2020. The employer can match the employee contribution at a level of 100 percent of up to the first 3 percent of compensation.
Small Business 401(k)/Defined Contribution Plans:
There are a few types of small business 401(k) plans. These can be set up by any employer with one or more employees. Some of these plans are more complex and require more administrative work and filing to set up. You might want to get advice and professional help from an employee benefit consulting firm or a financial institution to set up your 401(k).
- Traditional 401(k): Employees can contribute up to $19,500 as of 2020, with an additional catch-up contribution of $6,500 for employees age 50 and over. This money is deducted from the employee’s salary on a pretax basis. A Traditional 401(k) is also required to follow nondiscrimination rules and nondiscrimination testing, which make sure that contributions for employees are proportional to contributions made for the company’s owners and managers.
- Safe Harbor 401(k): Employee contribution limits are the same as the traditional 401(k), but Safe Harbor plans are not required to follow nondiscrimination testing like in a Traditional 401(k). That means the Safe Harbor 401(k) is often a better fit for businesses that have highly compensated employees whose retirement savings contributions would have been limited in a traditional 401(k). Employer contributions are 100 percent vested.
- Automatic Enrollment 401(k): This plan lets the company automatically enroll employees in the 401(k) plan; it’s a good way to help your employees save for retirement by “nudging” them to automatically enroll and start saving and investing for retirement.
Learn more from the IRS guide "401(k) Plans for Small Businesses."
Self-Employed 401(k) for Individuals
If you are self-employed, you can set up a one-participant 401(k) plan. You can defer up to $19,500 of your earned income in 2020 and 2021 (plus an extra $6,500 in catch-up contributions for people age 50 and over). As your (own) employer, your business as the employer can also contribute up to 25 percent of your compensation to your 401(k).
Total contributions to your 401(k) cannot exceed $58,000 for 2021; this does not include catch-up contributions for people over age 50.
Talk to an accountant and/or read the IRS guidelines for contribution limits to a self-employed 401(k). There are complications around the rules and how your compensation is counted as eligible for 401(k) contributions as a self-employed person.
Which Self-Employed Retirement Plan Is Right for You?
There is no simple answer for which small business retirement plan is the “right” choice. It depends on your specific situation: will you have employees, how much complexity are you willing to deal with, do you want to administer the plan yourself, can you get professional help to set up and administer the plan and more.
If you are a solopreneur or self-employed individual and are setting up a single-member LLC, it might be best to set up a SEP IRA, because it’s easy to manage and can let you contribute a significant amount of money to your retirement savings on a tax-advantaged basis.
If you will have employees, your options are more complicated. You might want to talk to a professional tax adviser or employee benefits consultant to get advice on how to choose the right plan for your needs and how to set it up in a way that works for your business.