Learn more about these 401(k)s and how you can use one to plan for your retirement.
How a Self-Employment 401(k) Plan Works
Self-employed 401(k)s allow small business owners with no other employees to contribute to a retirement plan as both an employee and employer. The same person makes both contributions. There are two types of contributions that can be made: elective deferrals and employer non-elective deferrals. Employees make elective deferrals and can include up to 100% of their compensation to the limit of $20,500 in 2022, increasing to $22,500 in 2023. The limits are adjusted every year or two to account for inflation and cost-of-living increases. Employees who are age 50 or older can make catchup contributions of an additional $7,500 per year in 2023, totaling $30,000, up from $6,500 in 2022 for a total of $27,000. The employer’s contributions, called non-elective deferrals, can be a maximum of 25% of compensation after deductions that are calculated using tables and worksheets provided by the Internal Revenue Service (IRS). The result is that business owners can contribute a total of $61,000 to their 401(k) plan in 2022, increasing to $66,000 in 2023, not including catchup contributions. Business owners can make contributions for both themselves and for their business when the plan is set up. They can make withdrawals and pay any necessary taxes when they retire. A business owner and their spouse can contribute employer plus employee contributions for each of them, earning interest and keeping that money protected from income taxes for decades.
An Example of Self-Employed 401(k) Savings
A husband and wife set up a limited liability company and launch a small business when they’re in their mid-20s. They earn enough revenue to pay themselves $175,000 per year before taxes by the time they’re 35 years old. The couple initially places $116,000 into their 401(k). They could continue putting that amount in their plan (adjusted for cost-of-living increases) but they decide to reinvest it into their business, taking $75,000 per year for living expenses. They earn 8% annually on their money over the next 25 years and continue to invest $24,000 per year, or $2,000 per month. Their combined 401(k) accounts would have more than $2.5 million waiting to fund their retirement. All that money would stay within the protected confines of the 401(k) account if the couple continued to work as outlined in this example. It would earn dividends, interest, capital gains, and profits without them having to pay any income taxes until they began withdrawing from the plan.
