Qualifying for a self-directed 401(k) plan is not difficult to qualify for, BUT it also does not permit one to establish the 401(k) plan just because they feel it is in their best interests. The IRS has identified conditions that must be met to qualify for any individual 401(k) plan, self-directed or not.
Further, keep in mind that to be considered self-employed and eligible to your self-directed 401(k) plan you must:
- Have the presence of self-employment activity, and presence of self employment activity.
- Not have any full-time employees.
Must Your 401(k) Generate Income?
This is always an interesting question as, in and of itself, a business is not required to earn income to justify the establishment of a 401(k) plan, self-directed or not. There can certainly be conditions where there is legitimate self-employment where, possibly, income (or much income) is realized. Does that mean that the person is not self-employed? Of course not.
However, the lack of income (and contributions) can be a slippery slope if a plan were to be audited. Why? While the general consensus is that the IRS’ main concern is that an individual is operating a legitimate business that is being operated to generate income/profit, there could be misunderstandings on this topic.
As an example, if you started a new business and rolled over $500,000 into your new 401(k) plan from another plan. Now, if you were operating your business for five years, you generated income and you never made a contribution, would the IRS question your ability to legitimately sponsor your plan? Possibly. It could be viewed that the plan was established more to rollover the other funds vs. operating your 401(k) plan with the intent of benefiting your retirement by making contributions to the plan from your self-employment activities. Again, it can be a slippery slope.
NO Common Law Employees!!
This is another consideration which can certainly cause compliance mistakes within a plan, and it is is a very simple happenstance that many can intentionally or unintentionally violate.
When you are establishing your plan, it is an individual plan! For it to be considered an individual plan, it cannot have any common law employees other than, potentially, a spouse that works for the business as well. The documents for the 401(k) plan are written to only permit one participant. Further, even IF the plan documents are amended to permit additional participants, annual non-discriminating testing on the plan must be executed and an annual Form 5500 for the plan must occur.
Unfortunately, a self-employed business owner may unintentionally hire what the IRS may consider a common law employee and still consider themselves self-employed. This unintended violation can create significant problems for the plan’s compliance and qualification requirements. The IRS has identified what defines a “common law” employee but, generally speaking, any employee hired as noted below will not be considered a common-law employee if:
- the employee is under the age of 21;
- the employee works less than 1000 hour per year; and,
- the employee is a non-resident employee.
Keep in mind that your business can employ individuals if they are under the age of 21, work less than 1,000 hours per year and are independent contractors retained by your business.
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