Successful self-employed business owners often seek the same pre-tax opportunities to save for retirement as employees of large corporations. Too often, they believe the only choice available to them is an IRA. This option may be appropriate for some but other business owners would like to be able to save more than the IRA limits ($6,000 per year for 2022 or $7,000 for people age 50 and older).
While many sole proprietors choose a SEP-IRA as their retirement savings plan, SEPs limit the amount account owners can contribute to 25% of their income. For business owners who want to maximize their retirement contributions and reduce their taxable income, a solo 401(k) plan may be a better alternative.
A solo 401(k), also referred to as an solo-k, individual 401(k), uni-k or one-participant 401(k), is a retirement plan designed specifically for businesses whose only employees are the owner and their spouse. In many ways, individual plans work in the same way as traditional 401(k)s, but there is a key difference: Solo 401(k)s are exempt from most of the Employee Retirement Income Security Act (ERISA) rules that traditional 401(k)s are subject to.
Who can benefit from a solo 401(k)?
Like traditional 401(k) plans, the primary benefit of a solo 401(k) is the ability for a business owner to reduce their taxable income and take advantage of tax deductions by making pretax contributions. If the owner’s spouse works for the business, they can also be included in the plan. If there are any other eligible (common‑law) employees, outside of the owner and spouse, however, the business will not be eligible to use the solo 401(k).
To be clear, business owners with full‑time employees who are older than 21 will be ineligible for the solo 401(k) and will need to choose another retirement plan avenue for making contributions.
How much can be contributed to a solo 401(k) plan?
Solo 401(k)s are subject to the same annual contribution limits as traditional 401(k)s. The 2022 annual limits are detailed below:
- Salary deferral contributions: Lesser of $20,500 or 100% of compensation; an additional catch-up contribution of $6,500 allowed if age 50 or older.
- Employer profit-sharing contributions: 25 percent of compensation or 20 percent of net self‑employment income if a sole proprietor.
- Total combined salary deferral and employer contributions: $61,000; $67,500 if catch-up contributions apply.
- Maximum compensation for contribution calculations: $305,000
Note that these are the IRS maximum contribution limits. Consult your tax advisor to determine the amount you are eligible to contribute.
Employer contributions can be made by the employer’s tax filing deadline, including extensions. Employee (salary) deferrals should be made as soon as administratively possible but no later than the employer’s tax filing deadline, including extensions.
Please note: Some plan documents may allow for after‑tax and Roth employee deferrals to be made as well.
Nondiscrimination testing, a series of calculations designed to ensure that a 401(k) plan does not unfairly benefit a certain employee or group of employees, is not required because there are no common‑law employees.
Account owners are eligible to withdraw assets from the plan when they meet one of the following triggering events:
- The plan’s normal retirement age (usually 59½);
- Permanent disability;
- Separation of service; or
- Plan termination.
Some solo 401(k) documents may also allow for distributions due to financial hardship and in‑service distributions prior to one of the triggering events listed above.
Required minimum distributions (RMDs) must begin at age 72. The RMD deferral option available for some participants in traditional 401(k)s is not available for solo 401(k) owners because they generally own more than 5 percent of their company.
Tax treatment of distributions
Any rollover-eligible distributions taken from plans that are not rolled over to another IRA or retirement plan will be subject to a 20 percent mandatory federal tax withholding. These distributions are taxed at ordinary income tax rates (unless deferrals were made on a Roth or after-tax basis), and early distributions are subject to a 10 percent penalty.
Distributions rolled over to another IRA or eligible retirement plan are done so as a direct rollover and are not subject to tax or penalty.
Participants are always 100 percent vested in employee and employer contributions.
A solo 401(k) can be designed to allow a loan feature for participants.
Plans with total assets less than $250,000 are exempt from the Form 5500 filing requirement, an annual reporting form for certain pension and welfare benefit plans, including 401(k)s. Once total plan assets reach $250,000 or more, the employer will be required to file Form 5500 each year. If a solo 401(k) is terminated, the employer is required to file Form 5500 for the year of termination, regardless of plan size.
Plan provider considerations and costs
Solo 401(k) plan providers and associated costs run the gamut. Some plans offered by brokerage companies don't charge annual maintenance or setup fees but do charge commissions when participants buy or sell funds. Some charge a fixed amount per fund held within the account. Some zero-cost plan providers don't allow for loans or other features. Other third party solo 401(k) plan providers charge between $20-$500 per year. Some charge one-time setup fees as well as annual investment fees.
Many investment advisers can set up solo 401(k) plans for their small-business-owner clients where they manage assets in the account, charging a percentage of assets under management.
Is a solo 401(k) right for you and your business?
It's important to thoroughly evaluate the potential pros and cons of any small-business retirement plan or provider before choosing an option. Working with a tax professional and a financial advisor can help you evaluate your options and make an informed decision.
Chris Gullotti is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or firstname.lastname@example.org.
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