It goes by many names – Solo 401(k), Mini 401(k) and single-participant 401(k). We will use Solo 401(k) in this article to describe probably the best type of pension plan for owner-only businesses. It provides for larger contributions, including a Roth option for a portion of the contribution, and the ability to borrow funds from the plan at reasonable rates. As a result, Solo 401(k) plans have become more attractive options than SEP-IRAs, Simple IRAs or profit-sharing or money purchase plans. In addition, if the plan permits and most do, assets for other retirement plans can be rolled over into the Solo 401(k) plan.
Generally, Solo 401(k) plans are a natural fit for two categories of businesses. The first includes independent contractors, sole proprietors, and owner-only C or S corporations. The second is those who have dual incomes. They are W-2 wage earners as employees of a company that offers a 401(k) plan who also have consulting income from corporate directorships or freelance work that requires them to file a Schedule C as a sole proprietor. Since the 401(k) contribution limits apply to each individual for the year and not the individual plans, if the taxpayer has multiple 401(k) plans, he or she needs to make sure that not more than the annual limit is contributed to the combination of plans.
The rules limit employer contribution (profit-sharing contribution) to 25% of compensation. The employee can also make salary deferral contributions up to $18,000*. Together, these contributions cannot exceed the lesser of $53,000* or 100% of compensation. In addition, if the employee is age 50 or over he or she can make an additional catch-up contribution of $6,000*.
Example – Susan Lewis, age 49, is the sole employee of an incorporated business. Her earned income is $100,000 in 2015. Under the law, Susan can contribute $25,000 to a SEP-IRA ($100,000 x .25), $15,500 ($12,500 plus 3% of $100,000) to a SIMPLE IRA and $25,000 to a profit-sharing or money purchase plan. However, she can contribute $43,000 to a Solo 401(k) plan ($25,000 employer contribution plus $18,000 employee deferral), still under the $53,000 maximum for the year. If Susan were age 50 or over, she could also make a catch-up contribution of $6,000, increasing her 401(k) contribution total to $49,000.
In some cases, 401(k) plan contributions for an unincorporated business may be slightly lower than the above amounts. For unincorporated businesses, compensation is net profit minus half of self-employment taxes minus employer contributions.
Although single-participant 401(k) plans are limited to the business owner and his or her spouse, business owners should note the added benefits of having his or her spouse as the business’s only other employee. Having the spouse on the payroll gives the business owner the opportunity to shelter some or all of his or her income by having the spouse make an elective deferral to a 401(k) plan in addition to the business making a profit-sharing contribution. Although the spouse and the business would be responsible for their respective share of employment taxes on the salary, combined employer and employee contributions can be up to the lesser of $54,000* or 100% of compensation. This limit applies separately to the business-owner and spouse, thus allowing a combined total of up to $108,000*. In addition, if age 50 or over, each individual could defer an additional $6,000 each year.
Potential downside – If a business grows and begins hiring employees, the single-participant 401(k) plan must become a full-blown 401(k) plan subject to other more stringent rules including discrimination testing that can serve to limit contributions by highly-paid executives. Many providers recommend that businesses with immediate expansion plans not set up one of the Solo 401(k) arrangements. Caution: If the business owner has other businesses or is part of a controlled group of corporations, partnerships, proprietorships or affiliated service groups, the employer aggregation rules may apply and the employees of those other businesses may have to be considered for purposes of meeting qualification and minimum coverage requirements for the Solo 401(k).
For additional information regarding Solo 401(k) plans and how it might fit into your tax strategy and retirement planning, please give this office a call. If you are considering a Solo 401(k) plan, be aware that the plan must be set up before year’s end.
* These values are inflation adjusted and are for 2017. Please call for the amounts for years other than 2017.