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A one-person 401k is an excellent tool for self-employed individuals saving for retirement, as well as certain partnerships when each partner sets up their own plan. These plans allow pretax savings, generous after-tax (Roth) contributions without income limits, and the ability to take loans, when needed.
They’re not nearly as complicated as large-company 401k plans, but there are several technical details you need to get right, and these plans are new to most people. Here are some tips for busy business owners, freelancers, and consultants to make your Solo401k experience as smooth as possible.
Goes by various names:
- IndividualK
- SoloK
- UniK
Must establish by 12/31 for most businesses? Not necessarily.
Note: Due to the SECURE Act, this rule is changing. The IRS allows you to establish a plan by your tax-filing deadline (plus extensions). There is still some outdated information in IRS rules that would point to establishing the plan by your year-end, just to be safe, if you plan to make salary deferral contributions. But if you’re just making profit-sharing contributions, the extended timeframe should be available.
Most businesses use the calendar year, but your tax filing deadline depends on the type of business you own: sole proprietorship, S-corp, etc.
This confuses a lot of people because other accounts — like Traditional and Roth IRA, as well as SEP plans for small businesses — long allowed you to open an account for the prior year if you do so before your tax filing deadline.
Establishing the plan is the key step. You don’t need to fund it right away, you just need to complete all of the requirements to open the account, which might mean signing the documents that establish your plan (and probably submitting, just to be safe, and so somebody can verify that the documents are in good order).
You can make contributions after year-end for the prior year. However, a few details:
- Salary deferral, like your Roth or pretax contributions, should ideally go into the account by 12/31 or shortly after, but that’s not necessarily a requirement. For owner-only plans, the IRS has stated that you have until your tax filing deadline, plus extensions, but please verify that this is still the case and triple-check with your tax professional. But if you run payroll and create W2 forms, you’ll need to know those contribution amounts to complete the forms.
- Your profit-sharing contributions can typically go in as late as your tax filing deadline, plus extensions. That might be late summer, in some cases, if you file extensions. The profit-sharing contribution is an additional pretax amount you can add based on your profits from the business, and it’s totally optional — you don’t need to make that kind of contribution
- You don’t need to make any contributions, really, but then what’s the point of having a plan? Plus, the IRS could ask some questions if you establish a plan and never actually use it. For example, it’s probably not unheard of for somebody to establish a plan with the intent to just take a loan and repay it. But I would not suggest doing something like that — you want to use these plans primarily for retirement savings accumulation.
Overcontributing (note the employer vs. employee limits):
If you work for an employer that offers a 401(k) plan, it’s critical to understand the maximum annual limits. For salary deferral, the limit on 401k contributions is combined, per taxpayer. You don’t get a separate salary deferral limit for each 401k plan when you work multiple jobs.
- For 2021, you can make salary deferral contributions—or “employee” contributions—of $19,500 (plus an additional $6,500 catch-up) if you’re 50 or older).
- For 2021, the total amount, including “employer” contributions (like profit-sharing, matching, and more) that can go into a plan for you is $58,000. If applicable, the catch-up can go in on top of that.
If you’re really hoping to save a substantial amount, here are a few tips:
- With different types of plans, you might be able to save more. For example, you might have a Solo 401k and your employer offers a 457. Or, maybe you’re able to make 403b “additional catch-up” contributions, enabling you to potentially save more than a single annual salary deferral limit.
- Employer contributions might be counted separately. So you can possibly receive substantial profit-sharing contributions from your employer and then make additional profit-sharing contributions to your Solo 401(k) plan. Check with a CPA before doing so, and don’t try to get fancy with making up separate employers so you can contribute more (it might make more sense to use a different type of plan, instead, plus you don’t want to do anything the IRS might view as a sham).
Important: Before you establish new companies or multiple retirement plans in an effort to maximize savings, research control group issues and speak with a pension expert.
Hiring an employee:
This isn’t a mistake by itself, but you may need to make adjustments if you start hiring. These plans are designed for self-employed individuals who have no employees besides a spouse.
Depending on your plan setup and the employee’s arrangement with you, you might be able to exclude part-time employees (less than 1,000 hours per year) and those under age 21. That might help keep things simple if you just have somebody working a few hours per week or during busy seasons.
But you need to verify what your plan document says before you assume anything.
If an employee can’t be excluded from the plan, you need to make changes. You might decide to change your plan to include the employee, and that’s a great employee benefit for a small organization to offer.
- The administrative costs will be higher, but maybe not as burdensome as you think.
- Your plan will need to pass nondiscrimination tests, which ensure that your employee is benefitting from the plan (not just you, the business owner).
- An easy way to pass those tests is to offer a safe-harbor contribution of 3% of the employee’s compensation
We don’t want to get into the weeds on bigger 401(k) plans. Just be aware that hiring may affect how your plan works, and you may need to change your setup if you add employees.
Owning multiple businesses:
If you’re hoping to carve out a business for yourself and avoid offering the plan to employees, that may be difficult or impossible. IRS rules look at common ownership of multiple businesses, and those rules might require you to establish a plan for everybody you employ, even if you can arguably say you have self-employment income in addition to your other business ventures. Talk with an expert before you open a plan for yourself.
File form 5500 after $250k:
Although Solo401k plans are quite simple, you need to file a return for your plan once plan assets reach $250,000. The IRS requires that you submit a form 5500, with a stiff penalty for failing to do so: $25 per day, up to $15,000.
In many cases, your plan administrator, CPA, or other service providers can do this for you. Your main responsibility is to make sure they complete that task and keep copies of the document. So, watch for that $250,000 mark and make sure the IRS gets the information they need.
- More reading: See the average retirement savings by age.
Need to take RMDs:
This quick tip is for when you’re age 72, 73, or 75 (previously 70.5). In a large company’s 401k plan, you might be used to ignoring the IRS required minimum distribution (RMD) rules while you’re still working. There is some limited ability to skip RMDs from a 401k plan while working for that employer. But those rules don’t apply to certain people — particularly business owners, in this case. Because you are more than a “5% owner of the business sponsoring the retirement plan,” the exception most likely does not apply to you, and you need to take RMDs. So, shifting funds to a Solo401k with the goal of dodging RMDs might not work out.
Please contact me if there’s anything I can do to help you with your 401k plan needs, whether it’s a one-person plan, you’ve got employees, or you have other financial needs like help with planning or investments. I’m a fee-only advisor, so we can work together without you needing to transfer your accounts, and I don’t earn any commissions for selling financial products. Whether you’re planning for your company or for yourself, I love answering questions about retirement. Thanks for watching.
Important information:
This content touches on complicated topics related to tax and employment law. The information on this page might not be accurate, up-to-date, or relevant to your situation. Do not make important decisions based on what you read here. Instead, speak with an expert who has a detailed knowledge of your situation and any applicable regulations. Approach Financial, Inc. does not provide tax or legal services.