Solo 401(k) eligibility for consultant receiving W2 for hourly rate?

[greenleafe]

Hi Bogleheads,

I am leaving my full-time job to become a consultant, and would like to start a solo 401(k) for my consulting income earned as a sole proprietor.

I have an existing 401(k) with my current employer , but my employer's plan will not allow me to just leave my current savings in that account after separation -- I am required to roll it over into a new 401(k) or an IRA within a certain period of time. (I also have a traditional IRA that could receive the rollover funds, but I try to make backdoor Roth IRA contributions annually, and I understand that having a high tIRA balance can mess up backdoor Roth IRA contributions because of the pro rata rule.)

I think it's possible for me to open a solo 401(k) with Schwab, and rollover my old 401(k) funds into the new solo 401(k) account. But I'm worried that the source of my consulting income could make me ineligible for doing a solo 401(k). My primary source (perhaps exclusive source) of consulting income for the next year will be my former employer. I will no longer receive benefits, will not be on salary, etc. Instead, I will send the company monthly invoices for my services at an hourly rate, and then they'll pay my invoices. (I asked if I could just stay in the 401(k) plan as a consultant, and they said no, their plan rules don't allow consultants to participate.) This company will send me a W2 at the end of the year rather than a 1099. I don't really have room to negotiate whether I get a W2 vs a 1099, because this is the company's standard procedure for its hourly consultants.

My concern is that, when I researched this issue on the Bogleheads forums, there are a few posts where users implied that only consultants who receive a 1099 are eligible to have solo 401(k)s, and anyone who receives a W2 cannot have a solo 401(k) for that income, even if the W2 is received as a consultant.

However, when I read up on solo 401(k)s and sole proprietorship on the IRS website and the Solo 401(k) Bogleheads Wiki entry, I couldn't find any clear answer about whether it matters if the consulting income comes with a W2 vs 1099. The only solo 401(k) eligibility requirements I found were along the lines of "sole proprietorship or LLC, no full time employees other than yourself," etc.

Can any kind Boglehead help me find out whether solo 401(k) eligibility is affected by receiving a W2 for consulting income rather than a 1099? Thanks in advance for your time, and for all your great advice over the years.

[Duckie]

greenleafe, welcome to the forum.

I am required to roll it over into a new 401(k) or an IRA within a certain period of time.

How much time do you have?

My primary source (perhaps exclusive source) of consulting income for the next year will be my former employer. I will no longer receive benefits, will not be on salary, etc. Instead, I will send the company monthly invoices for my services at an hourly rate, and then they'll pay my invoices. (I asked if I could just stay in the 401(k) plan as a consultant, and they said no, their plan rules don't allow consultants to participate.) This company will send me a W2 at the end of the year rather than a 1099.

That really sounds to me like you are a 1099-NEC. But if they insist on W-2 then you're probably stuck.

Can any kind Boglehead help me find out whether solo 401(k) eligibility is affected by receiving a W2 for consulting income rather than a 1099?

If you receive a W-2 then you are an employee of that company, not your own business. You can't contribute to a solo 401k for that income. Is it possible to be a consultant somewhere else at the same time? Even if that side gig pays little it would be enough to file Schedule C which would be enough to open a solo 401k. Once open you could roll the old employer plan in making the backdoor Roth method practical again.

[JBTX]

Not an expert, but pretty sure if you get w2 you are considered employee and cannot use solo 401k. Truth is some companies pay former employees as 1099 on a "consulting" basis but if somebody were to push the issue they are likely legally functioning as employees and should be w2. 1099 should really be independent in how they carry out their work. However it practically only becomes an issue if an employee sues or some sort of compliance audit takes place.

It seems like your employer is probably doing this the right way. I assume they are paying their side of the payroll tax, correct?

[MP123]

My concern is that, when I researched this issue on the Bogleheads forums, there are a few posts where users implied that only consultants who receive a 1099 are eligible to have solo 401(k)s, and anyone who receives a W2 cannot have a solo 401(k) for that income, even if the W2 is received as a consultant.

Income you receive on W2 is not self employment income and doesn't qualify for a solo 401k even if they call you a "consultant".

This doesn't prevent you from opening and contributing to a solo 401k on the basis of other income from a Schedule C business, S-Corp, or other self employment though. You can do both at the same time, but your contribution limits are based on the portion from self employment.

[Spirit Rider]

Either you are misunderstanding the company or they are misunderstanding the law/regulations.

They are correct that non-employees can not participate in a 401k plan.

However, if you have >= $5K in contributions and earnings. The 401k plan must allow you keep your assets in the plan after separation.

A company can hire a class of exempt non-benefit W-2 employees.

I hope you are getting a much higher hourly rate to compensate for the loss of benefits.

[AB609]

Since they are generating a W2 for you, are they also paying the employer half of the payroll tax?

[Spirit Rider]

Since they are generating a W2 for you, are they also paying the employer half of the payroll tax?

That is a given.

A W-2 employer is required to deduct the employee's share, file the necessary forms and send payment for both the employee's and the employer's share of FICA to the IRS.

[mikejuss]

My concern is that, when I researched this issue on the Bogleheads forums, there are a few posts where users implied that only consultants who receive a 1099 are eligible to have solo 401(k)s, and anyone who receives a W2 cannot have a solo 401(k) for that income, even if the W2 is received as a consultant.

Income you receive on W2 is not self employment income and doesn't qualify for a solo 401k even if they call you a "consultant".

This doesn't prevent you from opening and contributing to a solo 401k on the basis of other income from a Schedule C business, S-Corp, or other self employment though. You can do both at the same time, but your contribution limits are based on the portion from self employment.

+1

I'm in the same situation: an hourly employee who receives a W-2 at the start of the year. We're not able to contribute to an i401(k) without 1099 income. I'm not sure why 1099s are so rare for hourly workers these days, though I think it might have to do with most companies providing such workers with secure laptops, rendering us employees in the eyes of the IRS.

[Soon2BXProgrammer]

My concern is that, when I researched this issue on the Bogleheads forums, there are a few posts where users implied that only consultants who receive a 1099 are eligible to have solo 401(k)s, and anyone who receives a W2 cannot have a solo 401(k) for that income, even if the W2 is received as a consultant.

Income you receive on W2 is not self employment income and doesn't qualify for a solo 401k even if they call you a "consultant".

This doesn't prevent you from opening and contributing to a solo 401k on the basis of other income from a Schedule C business, S-Corp, or other self employment though. You can do both at the same time, but your contribution limits are based on the portion from self employment.

+1

I'm in the same situation: an hourly employee who receives a W-2 at the start of the year. We're not able to contribute to an i401(k) without 1099 income. I'm not sure why 1099s are so rare for hourly workers these days, though I think it might have to do with most companies providing such workers with secure laptops.

Its because under the employee/independent contractor test, you must fall on the employee side. Especially if they restrict you from doing the same work for your competitor.

Lets say you teach a class on customer service, and you teach it to McDonalds employees. if it is your class, and you can teach it to BurgerKing, then your probably an independent contractor.. If McDonalds says you cannot teach it to BurgerKing, because its their customer service intellectual property, then you are probably an employee.

[vitaflo]

I'm not sure why 1099s are so rare for hourly workers these days, though I think it might have to do with most companies providing such workers with secure laptops, rendering us employees in the eyes of the IRS.

Liability. As a 1099 if you do the same thing as an employee, but don't get benefits, well, aren't you just an employee that gets stiffed on benefits? In fact this is what happened a while back with Microsoft where 1099 contractors sued them for benefits. Ever since then corps have stopped dealing with 1099 workers. Too much liability.

This is why most corps only hire W2 workers from placement agencies ("preferred vendors" in their parlance) for contract work. It also helps because they only need to deal with a small list of preferred vendors and not hundreds of independent contractors. A lot of stupid stuff in big corps is just CYA stuff (see the entire HR department). This is just another example.

[greenleafe]

Thanks all for the thoughtful and very helpful replies! You’ve pointed out a distinction that I really hadn’t grasped; namely, that if I’m receiving a W2, then then that automatically means that the company must treat me as an employee for tax withholding purposes and those wages are de facto going to be treated as employee wages. So the “consultant vs employee” distinction for them is really just about whether or not I get benefits, and not whether I meet the IRS test for being an independent contractor.

As for next steps, I will go back to the company and see if they are willing to treat me as a 1099 consultant, and if not, I need to abandon the dream of a solo 401k for now. I suspect that I’ll be stuck with the W2 for some of the reasons mikejuss and vitaflow described.

Without boring you too much with the details, my employer actually would be happy to keep me on as a regular employee with benefits, but I no longer want to be full time, and am willing to give up the benefits in exchange for a fair hourly rate. It stings that I won’t be able to have a 401k, and this will probably screw up my backdoor Roth plans permanently, but oh well, can’t get everything!

SpiritRider, I’m definitely going to follow up on whether I actually have to roll over the 401k, because that sounds really familiar to me — that if you have a minimum number of assets in the plan, you’re allowed to keep it open but just not make new contributions. That would fix my backdoor Roth issue, so certainly worth double-checking!

Thanks again, all. This forum is the best!

[Thrifty Femme]

Would setting up a LLC and having the company pay the new LLC work for OP?

[niceguy7376]

I am leaving my full-time job to become a consultant, and would like to start a solo 401(k) for my consulting income earned as a sole proprietor.

So what exactly are you leaving and how did that decision come into existence? What are YOU gaining from this? You are still getting a W2 but no more allowed to contribute to the company 401k.

[MP123]

Would setting up a LLC and having the company pay the new LLC work for OP?

Yes, that would solve the issue with the i401k contribution. Hard to say if OP's employer would go for it though.

[Spirit Rider]

Would setting up a LLC and having the company pay the new LLC work for OP?

Yes, that would solve the issue with the i401k contribution. Hard to say if OP's employer would go for it though.

However, there is nothing different between the business paying the OP for independent contracting services as an LLC or a self-employed individual. The bottom line is still whether the OP is a W-2 employee or an independent contractor (IC). The business entity of the IC is irrelevant.

[Katietsu]

The first step as SpiritRider pointed out is to find out why you are being told that you need to move the funds if you have over$5000 in the 401k.

Also, will you still need to use the backdoor method to contribute to the Roth with your reduced hours?

[greenleafe]

KatieTsu, SpiritRider, I was able to speak with a more senior person in HR and got the correct info — I don’t have to roll over the 401k because I’ve met the $1k minimum threshold. So that’s a huge relief and will preserve my ability to go the backdoor IRA route without worrying about the pro rata rule. I still am interested in doing an individual 401k in the future, but will have to find some 1099 income first!

To niceguy’s question, I’m in the legal field, which has been great in many ways, but I started experiencing some mid-career burnout. I have a good relationship with my employer and so they’re accommodating my desire to improve my work/life balance by switching to this hourly consulting structure (and the hourly rate we’ve negotiated will enable me to cover my own benefits). I feel incredibly lucky in these stressful and uncertain times to be able to take a risk and reduce the number of hours I’m working.

That’s a big part of why I was focusing so much on the 401k issue — since I’m voluntarily going to be working less for at least the next year or two, I’m trying to ensure I still meet my retirement savings goals. Thanks again for the help, everyone.

[Spirit Rider]

KatieTsu, SpiritRider, I was able to speak with a more senior person in HR and got the correct info — I don’t have to roll over the 401k because I’ve met the $1k minimum threshold. So that’s a huge relief and will preserve my ability to go the backdoor IRA route without worrying about the pro rata rule.

Some additional clarification, because maybe even the more senior HR person may not fully understand the rules.

The are actually two thresholds ($1,000 and $5,000) and three different results based on your contributions and earnings balance. Rollover assets are not counted:

1. < $1,000: The plan can force you out of the plan with a distribution check. You could could do an indirect rollover, but pre-tax assets would have mandatory 20% withholding.
2. >= $1,000 and < $5,000: The plan can rollover to an IRA custodian of their choice. This is almost always custodian you never heard of with high costs. My cynical take; "Think kickback."
3. >= $5,000: The plan must allow your assets to remain in the plan. The employer can not charge you a discriminatory fee, but they can charge you the same fee they might be subsidizing for employees.

What is your contributions and earnings balance?

Note: In the first two cases, the employer must give you a 30-day notice. In which case you should ask for a direct rollover to a destination of your choice.

[greenleafe]

Spirit Rider, thanks for this, very helpful (and I definitely agree with your cynical take on rollover IRA custodian selection criteria). I’ve been lurking in the BH forums for a few years, which prompted me to contribute the max to my 401k for the past few years, with a classic 3-fund low ER portfolio. So I’m thankfully over the $5k contributions/earnings threshold, without counting funds that I previously rolled into the account. I hadn’t realized that prior rollover funds were treated differently for this purpose though, so I really appreciate your taking the time to highlight this point.