In 1978, a law was enacted and codified in section 401(k) of the Internal Revenue Code that gave taxpayers a break on taxes on deferred income. In 1980, a benefits consultant named Ted Benna used this provision in the tax code to create a tax-advantaged way to save for retirement. Now, anyone with a 401(k) can contribute up to $17,500 as an employee, and their employer can contribute an additional $34,500 in matching funds and profit-sharing arrangements. For someone 50 or older, the $17,500 goes up to $23,000 per year. That’s nearly nine times more than an individual can contribute to an individual retirement account.
Based on section 401(k), employees can make contributions to a 401(k) based on a pre-tax or post-tax basis, depending on what the plan allows. Any earnings from investments made through a 401(k) plan are either tax-deferred or tax-exempt, depending on whether the contribution is pre-tax or post-tax. Prior to 2006, with pre-tax contributions, the employee does not pay federal income tax on the amount of current income deferred to a 401(k) plan. Beginning in 2006, employees were allowed to pay the taxes on income prior to contributing it to their 401(k) plan. These designated contributions are known as Roth 401(k) contributions. Any earnings generated on investments made from a Roth 401(k) are tax-free.
Independent contractors should have a Self-Directed 401(k) account to complement their individual retirement account. You can have both retirement accounts at the same time, and you can contribute to both accounts each year, if you have sufficient earned income.
An independent contractor is defined by the Internal Revenue Service as any individual who “has the right to control or direct only the result of the work and not what will be done and how it will be done.” You are not an independent contractor if you perform services that can be controlled by an employer who tells you what will be done and how it will be done. What matters is whether or not the employer has the legal right to control the details of how the services are performed. People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors and anyone who works on commission, such as independent salespeople and real estate professionals, are independent contractors if they are in an independent trade, business or profession in which they offer their services to the general public.
If you are an independent contractor, you are self-employed. The earnings of a person who is working as an independent contractor are subject to self-employment tax.
One-Participant 401(k) Plan
Independent contractors are eligible to set up Self-Directed One-Participant 401(k) plans in addition to IRAs. The One-Participant 401(k) plan is sometimes called a Solo or Individual 401(k) plan, depending on the custodian involved. The One-Participant 401(k) plan covers a business owner with no full-time employees, except for his or her spouse. Both the employee and the spouse can have One-Participant 401(k) plans.
In a One-Participant 401(k) plan, the owner wears two hats: employee and employer. Contributions can be made to the plan in both capacities. As employee and owner of the plan, you can make annual elective salary deferrals up to 100 percent of your earned income. For 2014, that’s $17,500 if you are under 50 years of age and $23,000 per year if you are 50 or over. As employer, you can make non-elective contributions up to 25 percent of compensation as defined by the plan. In 2014, total contributions to a participant’s account, not counting catch-up contributions of $5,500 if you are 50 or older, cannot exceed $52,000.
Employee and Independent Contractor
If you are an independent contractor and also an employee of a company that allows you to participate in its 401(k) plan, you should bear in mind that your limits on elective deferrals is by person and not by plan. That means you can have two 401(k) plans, one with your employer and one with your own company, if you are working as an independent contractor on the side. This applies to many people who work for a company part-time and are also a full-time RealtorÒ. If you work for a primary employer and participate in that company’s 401(k) plan, you can also make additional contributions as an employee of your part-time business.
In addition to sole proprietors and self-employed individuals, business entities such as partnerships, limited liability companies (LLCs), S corporations and C corporations are also eligible. The business owner must intend to make a profit, but there is no threshold as to how much profit the business must generate. The contributions must be made from earned income.
Why an Independent Contractor Should Have a Self-Directed One-Participant 401(k)
There are three reasons why an independent contractor should have a Self-Directed One-Participant 401(k) retirement account: (1) You have the ability to invest in other types of assets other than stocks, mutual funds and bonds; (2) You have the ability to create wealth using tax-deferred and tax-free income; and (3) You do not pay taxes on the compounded earnings until you retire; IRAs are taxed on a portion of the earnings if you buy leveraged real estate; 401(k)s are not.
Invest in Income-Producing, Leveraged Real Estate
The best alternative investment to stocks and mutual funds, which are extremely volatile, is income-producing, leveraged real estate. Stockbrokers and financial planners are precluded from letting you invest in real estate directly with your retirement account. If you have a self-directed retirement account, you make the decisions as to what you invest in.
If you want to create wealth faster, invest in income-producing, leveraged real estate. By purchasing leveraged, income-producing real estate, you can buy more assets with less capital, which doubles or triples the returns you can achieve. By having those earnings in a tax-deferred or tax-free account, they have the potential to compound faster, thus creating significantly more wealth in a shorter period of time. By investing in income-producing, leveraged real estate, you can retire and live off of the income generated from your investments rather than being forced to liquidate your investments to live off of the sales proceeds.
Ken Holman is president and owner of the National Association of Real Estate Investment Advisors. If you want to create a Self-Directed One-Participant 401(k) plan, contact Mr. Holman at email@example.com. He can steer you in the right direction. To learn more about investing in real estate, sign up for one of his investment classes at www.NAREIAGroup.org.