A solo 401(k) plan is a retirement plan created to help a sole proprietor or small business with no full-time employees save for retirement. Because a business that is eligible to adopt a solo 401(k) plan does not have any non-owner full-time employees, the IRS is typically not focused on offering additional tax benefits for adopting the plan. In almost all instances, Congress and the IRS reserve additional tax benefits as an incentive for a business with non-owner employees to establish a plan and offer plan benefits to its employees. However, the Secure Act 2.0, which became law in December 2022, a provision that targets businesses with non-owner employees, seemingly offers solo 401(k) plans with a tax credit of up to $1500. Hence, any business that is eligible to establish a solo 401(k) plan in 2023, 2024, or 2025 that includes an auto-enrollment option, would be eligible to generate a $500 annual tax credit over three years which essentially allows the business to establish a solo 401(k) plan for free.
The SECURE Act 2.0
An important and wide range of retirement-related provisions known as “SECURE 2.0” is included in a 4000+-page, $1.7 trillion spending bill — which would fund the government for the 2023 fiscal year — that was unveiled on December 20, 2022. Secure Act 2.0 included several important new retirement provisions, including the following incentives via tax credits for businesses to establish 401(k) plans and increase benefits to their employees.
New 401(k) Start-Up Credit
Current law offers a tax credit to a small business (up to 100 employees) that adopts a new qualified plan, which can apply for up to three years, equal to the lesser of (1) 50% of the employer’s start-up costs, or (2) as much as $5,000. 50% would be increased to 100% in the case of employers with 50 or fewer employees. The credit is available to qualified plans (DB/DC), SEPs, and SIMPLEs with “non-highly compensated employees.” A non-highly compensated employee is defined as an employee who is not highly compensated. Whereas a highly compensated employee is an employee who:
- Owns more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
- For the preceding year, received compensation from the business of more than $150,000 for 2023 and,
- if the employer so chooses, was in the top 20% of employees when ranked by compensation.
Since a solo 401(k) plan by definition does not include any non-owner employee or “non-highly compensated” employee, this new start-up plan tax credit does not apply to a solo 401(k) plan.
Employer Contribution Credit
For taxable years beginning after 2022, the new employer contribution tax credit is a decreasing percentage of the amount contributed by the employer for each employee earning no more than $100,000 per year, up to $1,000 annually per employee, over the plan’s first five years. Like the start-up plan tax credit, this credit is only available if contributions are made to “non-highly compensated” employees. Thus, since a solo 401(k) plan by definition does not include any non-owner employee or “non-highly compensated” employee, this employer contribution credit does not apply to a solo 401(k) plan.
Auto Enrollment Credit
SECURE 2.0 requires certain plans starting after December 29, 2022, to use automatic enrollment. While the requirement is not effective until 2025, The credit is $500 per year for the first three years the feature is included, or $1500 in total. What is interesting about the auto-enrollment tax credit is that it does not formally require that the plan have any “non-highly compensated” employees. Many tax and ERISA attorneys have been confused about why the language in SECURE 2.0 relating to this credit does not reference the need that the plan to utilize the auto-enrollment feature have a “non-highly compensated” employee. A solo 401(k) plan is adopted by a business that does not have any non-owner “full-time employees” and would thus, not have any “non-highly compensated” employee to auto-enroll. In other words, there would be no need for a solo 401(k) plan to include an automatic enrollment feature since there are no non-owner full-time employees to auto-enroll. Nevertheless, the language in SECURE 2.0 pertaining to the auto-enrollment tax credit does not reference the requirement that the business electing to use the auto-enrollment feature have any “non-highly compensated” employees.
What is the omission of the requirement that the business electing to use the automatic enrollment feature have any “non-highly compensated” employee a mistake by the drafters of the provision? Many tax professionals believe so on the basis that there is no real need for a solo 401(k) plan to have an automatic enrollment feature because it does not have any non-owner full-time employees, including any “non-highly compensated” employees. Why would the IRS offer a tax credit incentive for a business owner to auto-enroll himself or herself? It makes no sense. Nonetheless, the language relating to this provision does not include any reference for the business electing to use the automatic enrollment feature having any “non-highly compensated” employee. Thus, so long as your solo 401(k) plan contains the automatic enrollment option in the 401(k) plan documents, SECURE 2.0 seemingly offers a business with a solo 401(k) plan with a $1500 tax credit so long as they simply elect to include the automatic enrollment option in their solo 401(k) plan documents.
A business with a solo 401(k) plan that elects to use the auto-enrollment option in their plan docs can take advantage of the annual $500 tax credit for three years by filing IRS Form 8881.
Tax Credit Vs Tax Deduction
In sum, a tax credit is far more advantageous than a tax deduction. A tax credit is a dollar-for-dollar reduction of the income tax owed. A tax credit directly decreases the amount of tax you owe. For example, if you owe $25,000 in taxes to the IRS and you have a $3000 tax credit, you will pay tax on $22,000. Whereas a tax deduction lowers a person’s tax liability by reducing their taxable income. Hence, a tax credit is far superior to a tax deduction because a tax credit directly lowers one’s tax liability, whereas a tax deduction just lowers the amount of tax you owe.
Why Do I Need to Set Up a Solo 401(k)?
A solo 401(k) plan is not a new type of retirement plan. It is a traditional 401(k) plan covering only one employee. In general, to be eligible to establish a solo 401(k) plan, one must be self-employed or have a small business with no full-time employees (over 1000 hours during the year) other than a spouse or other owner(s).
A Solo 401K plan is perfect for any sole proprietor, consultant, or independent contractor. To be eligible to benefit from the Solo 401(k) plan, investors must meet just two eligibility requirements:
- The presence of self-employment activity.
- The absence of full-time employees.
The business owner and their spouse are technically considered “owner-employees” rather than “employees.
The following are the major advantages of establishing a solo 401(k) in 2024:
- High Contribution Limits: With a Solo 401(k) Plan, a plan participant of a Solo 401(k) Plan can make annual contributions of up to $69,000 annually with an additional $75,000 catch-up contribution for those over age 50 in 2024.
- Loan Feature: With the Solo 401k Plan, a plan participant is eligible to borrow up to $50,000 or 50% of their account value (whichever is less) for any purpose, including paying credit card bills, mortgage payments, personal or business investments, a car, vacation, or anything else. The loan has to be paid back over five years at least quarterly at a minimum prime interest rate (you have the option of selecting a higher interest rate)
“Checkbook Control”: One of the most popular features of the solo 401k Plan is that it does not require the participant to hire a bank or trust company to serve as trustee. This flexibility allows the plan participant (you) to serve in the trustee role. This means that all assets of the 401(k) trust are under the sole authority of the Solo 401k participant. A solo 401(k) plan allows you to eliminate the expense and delays associated with an IRA custodian, enabling you to act quickly when the right investment opportunity presents itself. Making a solo 401(k) Plan investment is as simple as writing a check.
Mega Roth: Contribute up $69,000 or #7$6,500 all in Roth with the “mega backdoor” Roth option. Keep the funds in Roth in the plan or even rollover the Roth funds to a Roth IRA tax-free.
Secret Weapon for Real Estate Investors: Pursuant to Internal Revenue Code Section 514, a Solo 401(k) is not subject to the unrelated business taxable income tax (UBTI or UBIT) on the use of a nonrecourse loan (leverage) in connection with the purchase of real estate. Whereas, an IRA that uses leverage to purchase real estate would be subject to the UBTI on the debt-financed portion of the property. The current maximum UBTI tax rate is 37%.
Conclusion
Thanks to a quirk in the language of the auto-enrollment credit in SECURE 2.0, a business that establishes a solo 401(k) plan in 2023 or 2024 could generate tax credit of $500 for the next three years up to a total tax credit of $1500. Therefore, a sole proprietor or small business owner that opens a solo 401(k) plan can now reduce their tax liability by over $1500 over 3 years. In other words, the IRS has likely “accidentally” included a $1500 tax credit to millions of sole proprietor and eligible small business owners with no “full-time” employees who adopts a solo 401(k) plan.
