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Robert Bloink and William H. Byrnes
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What You Need to Know

  • Solo 401(k)s allow your self-employed clients to make large retirement contributions with little administrative overhead.
  • But if they hire someone other than a spouse, their plan no longer qualifies as a solo 4001(k).
  • These clients should notify their providers immediately to avoid penalties and learn about ways to ease the burden.

Solo 401(k) plans provide a powerful retirement savings option for the smallest businesses that have no employees.

When the plan only covers a business owner and their spouse, the IRS waives much of the red tape that typical 401(k) sponsors must navigate to qualify for tax advantages. After all, a business owner cannot discriminate in favor of highly compensated executives when they have no employees to begin with.

That said, business structures change over time as a business grows. Small-business clients who adopt solo 401(k)s must be advised about the rules that govern these plans — and be prepared to take action should they eventually hire a common-law employee who satisfies the plan’s age and service eligibility requirements.

Solo 401(k)s: The Basics

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same manner as a traditional 401(k)—contributions are made on a pretax basis and subject to ordinary income taxes when withdrawn during retirement.

However, these plans have their advantages due to greater administrative simplicity. One key advantage of a solo 401(k) plan is that the business owner isn’t required to perform nondiscrimination testing because there are no employees to protect (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. Plan sponsors have no obligation to delivery traditionally required ERISA Title I notices to participants.

Solo 401(k)s also allow the owner to make larger contributions each year. In 2023, the owner-employee can contribute up to $22,500 ($30,000 if the participant is 50 or older) in pretax dollars per year as an employee. Business owners are also permitted to contribute up to $43,500 to the plan as employer — for a total employer-employee contribution limit of $66,000 in 2023, without catch-up contributions, or $73,500 for those aged 50 and older.

However, employer contributions are also generally limited to 25% of compensation, up to the overall maximum of $66,000 (or $73,500, considering catch-up contributions).

Solo 401(k)s are also not required to carry “fidelity bonds” to protect participants from fraudulent acts, because solo plans are not ERISA-covered plans.

Impact of Hiring an Employee

A business owner should notify their solo 401(k) provider immediately upon hiring an employee. As soon as at least one common-law employee meets the age and service requirements, the plan no longer qualifies as a solo plan. That’s true even if that employee chooses not to participate in the plan. 

Eligible employees can include both full-time employees who work at least 1,000 hours per year and long-term part-time employees. (Eligible part-time employees include those with at least 500 hours of service over a three-year period (two years starting in 2024)).

There are, however, steps the employer can take to retain a lower administrative burden. If the plan is amended to add a safe harbor feature, the plan will automatically be deemed to satisfy nondiscrimination testing and top-heavy testing.

For a safe harbor plan, the amendment must be made by the last day of the year preceding the year in which the plan will obtain safe harbor status. Notice must be provided to plan participants between 30 days and 90 days prior to the start of the plan’s safe harbor year.

The Setting Every Community Up for Retirement Enhancement (Secure) Act changed the rules for nonelective safe harbor plans. Plan sponsors are permitted to amend their 401(k) plan documents to provide for safe harbor nonelective contributions (1) no later than 30 days prior to the end of the plan year or (2) if the employer contribution is at least 4% of employee compensation, after 30 days prior to the end of the plan year and before the last day for distributing excess contributions to the plan (usually, by the end of the next plan year).

The notice requirements for safe harbor nonelective contributions of at least 3% of employer compensation has been eliminated (notice requirements for plans that provide only for an employer match remain in place). 

Business owners should also consider removing voluntary contribution options. If the solo 401(k) contained a voluntary contribution option, it can be difficult to satisfy nondiscrimination testing (ACP testing will be required if voluntary contributions are made during a year in which an employee was an eligible participant even if the plan otherwise qualifies as a safe harbor plan).

The owner should also purchase a fidelity bond as required under ERISA once the plan loses solo status.

Conclusion

Because solo 401(k)s automatically lose their qualified plan status as soon as a common-law employee meets the plan’s age and service eligibility requirements, it’s critical for small-business clients to notify their 401(k) provider for help amending the plan documents as soon as this becomes an issue. Otherwise, the owner risks disqualification, penalties and contribution refunds.


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