I often have two classes of individuals who inquire about self-directed plans. The first are individuals who inquire about a SD (Self-Directed) IRA, even WHEN they may qualify for a SD 401K. The second group of individuals are ones that call about a SD 401K thinking that they can automatically set up a 401K, regardless of their circumstances. Well, as you can probably tell, there are individuals who THINK they can only qualify for an IRA (typically because their funds are already in an IRA so they erroneously believe they have to establish an IRA), when they might be able to qualify for a 401K. Then there are individuals who believe (typically) that because they have an “old” 401K plan from a previous employer, that those funds would go right into a SD 401K.
While I am big fan of a 401K vs. an IRA when it comes to SD plans, one must qualify for the 401K as a self-employed individual. But, there is confusion with how one qualifies for a 401K. Most believe, incorrectly, that if they are a W-2 employee, there is no way they can qualify for a 401K. This, potentially, is not the case.
First, the IRS does not preclude an individual from participating in more than one qualified retirement plan, provided the total amount of contributions does not exceed what the IRS permits for an individual and plan. Thus…and you see where I am going with this….one could potentially be a W-2 employee who participates in a 401K plan at their job AND have a SD 401K for a side business they may operate. But, in saying this, for tax purposes, what does the IRS consider needing to take place for an individual to be Self-Employed?
The IRS considers an individual to be Self-Employed provided any of the following apply:
1) A taxpayer carries on a trade or business as a sole proprietor or an independent contractor.
2) A taxpayer is a member of a partnership that carries on a trade or business.
3) A taxpayer is in business for himself or herself.
The next question you may ask then is how does the IRS define a trade or business?
Well, a trade or business is generally an activity carried on for a livelihood or in good faith to make a profit. Obviously, most trades or businesses are established for the sole purpose of making a profit. However, is it required? The IRS has specifically stated that a taxpayer does not need to actually make a profit to be in a trade or business as long as the taxpayer has demonstrated that they have a motive to make profit.
So, to kind of string this out further, can you have a part-time business and qualify for your own 401K? Yes. The IRS has stipulated that a taxpayer does not have to carry on full time activities of a trade or business to be considered to be self-employed. Thus, having a part-time business in addition to your W-2 position is considered as being self-employed.
So, what about a Sole Proprietor? The IRS considers a taxpayer that owns their own unincorporated business as a sole proprietor.
So, what about an Independent Contractor? This can be confusing and in many cases, individuals who believe they are independent contractors are not, and individuals who believe they may be W-2 employees actually are independent contractors. Typically, cases can and are reviewed on a case by case basis. However, one general rule regarding independent contractors is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done or how it will be done. Earnings of an independent contractor are not taxed as a payroll tax but rather are subject to the self-employment tax.
?Further, the IRS has stated, “a taxpayer is not an independent contractor if they perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed. If an employer-employee relationship exists (regardless of what the relationship is called), that taxpayer is not an independent contractor and his or her earnings are generally not subject to SE (self employment) tax.”
So, that’s good to know, but my situation is much easier….if I am self-employed with no employees and only a spouse, can I qualify for a SD 401K?
Quite simply, YES. As you have seen from some other posts on this topic, the regulations for individual 401K plans (that are limited to no more than an employee and his/her spouse) are quite simplistic and are not required to meet some of the more stringent standards of a 401K plan that has employees.
So, keep these requirements in mind:
If I have employees, can I establish a SD 401K? Yes, but the employees could not work more than 1,000 hours per year. Conservatively, when there are no employees, there can never be an issue…right? If you retained independent contractors, these individuals would not disallow you to establish and maintain a SD 401K plan. My suggestion is to give careful consideration to establishing a SD 401K IF you have employees AND ALWAYS consult with a tax professional.
What if my spouse works for me, can he/she participate in the 401K plan? Yes, but the spouse must be on payroll or receive business compensation from the business for business activities. The main thing to consider is that the regulations permit a spouse to be included, but not require that the spouse must be included.
Hopefully, this addresses some issues related to SD 401K plans. For anyone with whom I have ever spoken, if they qualify for the 401K, I highly recommend that they consider the 401K over the IRA for a plethora of reasons….many spoken about on this site. Regardless of a 401K or an IRA, SD accounts provide the individual the freedom and flexibility to invest their retirement funds as THEY see fit in the asset classes that THEY wish to invest in….provided, of course, that the individual always follows all IRS and, if applicable, ERISA regulations.