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What You Need to Know

  • A solo 401(k) plan covers only the business owner and their spouse.
  • The IRS wants to know if small entrepreneurs have exceeded the annual pretax contribution limits.
  • Small-business owners often put documentation on the back burner.

Sole proprietors who maintain solo 401(k)s are able to capitalize on a number of benefits — from increased contribution limits to relatively minimal compliance requirements. In fact, compliance requirements are so minimal that business owners often forget about them until there’s a problem. For those business clients, it’s time to take notice. The IRS has recently announced that solo 401(k)s will be the focus of increased audit efforts — meaning that if your business client contributes to a solo 401(k), it’s time to review their status to determine whether everything is in order.

Solo 401(k) Requirements

A solo 401(k) is a 401(k) plan that covers only the business owner (the plan can also cover a spouse). In most ways, the solo 401(k) operates in the same manner as a traditional 401(k) —contributions are made on a pretax basis and subject to ordinary income taxes when withdrawn in retirement.

One key advantage of a solo 401(k) plan is that the employer-participant isn’t required to perform nondiscrimination testing because there are no employees, non-highly compensated or otherwise. Filing requirements are also minimal — if the plan’s assets are at least $250,000 at year-end, the plan is required to file an annual report on Form 5500-EZ.

Solo 401(k)s also allow the owner to make larger contributions each year. In 2021, the owner-employee can contribute up to $19,500 ($26,000 if the participant is 50 or older) in pretax dollars per year as an employee. The business owner is also permitted to contribute up to $38,500 to the plan as employer (for a total employer-employee contribution limit of $58,000 in 2021, or $64,500 for those aged 50 and up). 

However, employer contributions are also generally limited to 25% of compensation, up to the overall maximum of $58,000 (or $64,500, considering catch-up contributions).

The Focus of IRS Audits

Sponsors of solo 401(k)s are not permitted to have any employees. Thus, business owners who recently hired employees will no longer qualify for the solo 401(k) structure — meaning that they’ll be subject to the traditional nondiscrimination requirements that apply generally to 401(k) plans unless they satisfy certain safe harbor criteria.

In the past, in terms of 401(k) participation rules, most part-time employees didn’t qualify for employee status — only traditional full-time employees who worked at least 1,000 hours in any 12-month period had to be offered participation rights. 

Post-SECURE Act, however, certain long-term, part-time employees must be granted eligibility to participate in the employer-sponsored 401(k). Under the new law, employees who perform at least 500 hours of service for at least three consecutive years (and who are at least 21 years old) must also be allowed to participate in the employer-sponsored 401(k). Employers aren’t required to count years before 2021 in determining whether an employee must be granted participation rights.

The IRS is also interested in whether small entrepreneurs have exceeded the annual pretax contribution limits. As noted above, taxpayers can contribute to a solo 401(k) as both employer and employee. However, the deferral limits apply on a per-person basis, not a per-401(k) basis. Many entrepreneurs who operate “side gigs” form their own solo 401(k)s to take advantage of the increased pretax contribution limits while also participating in an employer’s plan.

Documentation is another issue that commonly gets put on the back burner. The solo 401(k) sponsor is required to maintain a written plan document and operate the plan in accordance with that document. It’s important to update the document from time to time to reflect changes in the tax law. With the significant changes we’ve seen in the past few years, every solo 401(k) sponsor should be reminded of the need to review the plan document carefully to make any required changes.

Conclusion

Performing relatively routine self-compliance checks is key to avoiding unwanted attention from the IRS. And with solo 401(k)s on the radar for 2021, small-business clients should begin those examinations now so that they can correct any errors before the IRS takes notice.

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