A Solo 401(k) plan is not a new type of retirement plan. It is a traditional 401(k) plan covering only one employee. A 401(k) plan is a special type of profit-sharing plan and is named after the subsection of the Internal Revenue Code that describes it. A traditional 401(k) plan allows you to direct some of your compensation into the plan and you do not have to pay income taxes on the portion of your salary you direct into the plan until the funds are withdrawn. In addition to regular contributions, you can also make Solo 401(k) employer profit sharing contributions.
- The Solo 401(k) is the best plan for the self-employed
- You contribute to the plan as both the employee and the employer
- Not all plan participants have to contribute the same percentage
Who Can Set-Up a Solo 401(k)?
In general, in order 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).
As the name implies, the Solo 401(k) plan is an IRS-approved qualified 401(k) plan designed for a self-employed individual or the sole owner-employee of a corporation. It works best when there are no other employees or a very small number of employees.
A Solo 401(k) plan is well suited for businesses that either do not employ any employees or employee certain employees that may be excluded from coverage. 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 types of employees may be generally excluded from coverage:
- Employees under 21 years of age
- Employees that work less than a 1000 hours annually
- Union employees
- Nonresident alien employees
In other word, any US based business that has no full-time employee from any non-owner or spouses can establish a Solo 401(k) plan. That includes a business that has multiple partners/owners with no full-time employees.
Solo 401(k) Contribution Rules
One of the biggest advantage of establishing a Solo 401(k) plan is the high annual maximum contribution limits. A Solo 401(k) participant can contribute to the plan as an employee and as the employer.
Employee Elective Deferrals
For 2021, up to $19,500 per year can be contributed by the participant through employee elective deferrals. An additional $6,500 can be contributed for persons at least age 50. These contributions can be up to 100% of the participant’s self-employment compensation. Employee deferrals are 100% elective and are based on each plan participant’s net Schedule C or W-2 amount. Employee elective deferrals can be made in pretax or Roth and are calculated dollar-for-dollar based on one’s income, net of self-employment tax or social security and Medicare tax for W-2 taxpayers. For example, a plan participant under the age of 50 that makes $25,000 of W-2, can make an employee elective deferral of $19,500.
Employer Profit Sharing Contributions
Through the role of employer, an additional contribution can be made to the plan in an amount up to 25% of the participant’s self-employment compensation or W-2 income. Employer profit sharing contributions must be made with pretax funds. In general, if a business has multiple plan participants, the employer profit sharing contribution percentage will be the same percentage for both plan participants. For example, if a business has three partners and no full-time employees other than the owners, and the partners decided that the business would do a 20% employer profit sharing contribution, then typically each partner would get an employer contribution equal to 20% of their W-2 or guaranteed payment compensation amount. However, what if one of the partners did not want to receive a 20% employer contribution from the business for some reason. Can the business select different employer contribution percentages for certain employees?
Using Different Employer Profit Sharing Contribution Percentages in a Solo 401(k)
Not all Solo 401(k) plans are the same. The plan documents dictate the type of plan options your plan will have available to its participants. For example, some plans do not allow for Roth contributions, offer a loan feature, or even allow for alternative assets, such as real estate, even though they are available plan options under the law. The same goes for granting a business the ability to use different employer profit sharing contribution percentages for owners/partners.
For a W-2 owner/employee, so long as the plan docs allows for it, the profit sharing contributions do not have to technically use the same percentage, but often do. For example, if a corporation has two shareholders, one shareholder can get a 25% employer contribution based on his or her W-2 and the other partner can get a different percentage. The nice thing with W-2 owners is that the owners can use the excess profit sharing contribution not used by the other partners for themselves. This is not very common since most owner/partners want equal plan benefits, but it does happen where one owner may want more W-2 compensation instead of receiving a higher 401(k) plan contribution.
Whereas, if each owner is a 1099 taxpayer (Schedule C), some Solo 401(k) plan documents will allow each owner/partner to be placed in his or her own group and each owner.partner can then do his or her own percentage, but are limited to 20% of their compensation. The Solo 401(k) plan document has to be customized to offer this option.
In other words, so long as you have the right Solo 401(k) plan document, such as a plan established by IRA Financial, your Solo 401(k) plan can include an option allowing your business to use different employer profit sharing contribution percentages for each owner/partner/shareholder, irrespective of whether the adopting employer is a sole proprietor, LLC, or corporation.
Total Solo 401(k) Plan Limit
The sum of both employee deferral and employer profit sharing contributions for a Solo 401(k) can be a maximum of $58,000 per year (for 2021) or $64,500 for persons at least age 50. If the business owner’s spouse elects to participate in the Solo 401(k) and earns compensation from the business, the spouse is allowed to make separate and equal contributions increasing the couples’ annual total contribution to $116,000 for 2021 or $129,000 if both spouses are at least age 50.
Get in Touch
To learn more about the benefits of establishing a Solo 401(k) plan for your business and how you can maximize your retirement plan contributions, please contact a Solo 401(k) plan specialist at 800-472-0646.
