Solo 401(k) Rules & the Sole Proprietor

Over the last twenty or so years, the Solo 401(k) plan has become the most popular plan for the self-employed and small business owner.  It has many popular retirement and investment options, including high annual maximum contributions, a $50,000 tax-free loan option, checkbook control, easy administration, the Mega Backdoor Roth solution, as well as no tax on using leverage to acquire real estate.

Other than the annual contribution rules, irrespective of whether you are a sole proprietor, LLC, or Corporation, all the aforementioned plan options will be available based on your plan documents.  However, the Solo 401(k) contribution amount and deadline for making said contributions do differ based on whether the adopting employer is a sole proprietor, single member LLC, multiple-member LLC, C or S Corporation.  This article will explore the contribution rules for a sole proprietor.

What is a Solo 401(k)?

A Solo 401(k) plan, also known as an Individual 401(k) or Self-Employed 401(k) plan, among other names, is a retirement plan that must be adopted by a business that does not have any non-owner full-time employees.  To be considered a full-time employee has to work 1,000 hours during the year, or 500 hours for three consecutive years.

The IRS designed the Solo 401(k) plan specifically for the self-employed. It offers them the benefits of a workplace retirement plan in conjunction with the freedom of a Self-Directed IRA.

You gain the ability to make high annual contributions (up to $61,000 or $67,500 if at least age 50 for 2022) while using those funds to make almost any type of investment, including real estate, on your own tax-free! Plus, you can borrow up to $50,000 from the plan, make Roth-type contributions with minimal administrative attention.

With a Solo 401(k) plan, the account can be opened at any local bank, and you serve as the trustee.  Accordingly, as trustee, you have control over your retirement funds to make the investments you want, when you want.

What is a Sole Proprietor?

According to the IRS, a sole proprietor is someone who owns an unincorporated business by himself or herself. Basically, if you have run a business and have not established an entity for that business, such as an LLC or corporation, by default, you are deemed a sole proprietorship. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

A sole proprietorship will report its business income or losses using Schedule C on IRS Form 1040 (Federal income tax return). The main disadvantage of using a sole proprietorship to operate a business is that the business owner is not able to benefit from limited liability protection, which would be available via the establishment of an LLC or corporation.

Solo 401(k) Contribution Rules – Sole Proprietor

Any sole proprietor that wishes to make high annual tax-deferred or Roth contributions, would benefit greatly from establishing a Solo 401(k).

Contributions to the plan can be made as both the employee (elective deferral) and the employer (profit-sharing). The plan participant can make a dollar-for-dollar elective deferral of up to $20,500.  If you are at least age 50, you can make an additional “catch-up” contribution of up to $6,500.  The contribution can be made as pretax, after-tax or Roth.

On the profit-sharing side, a sole proprietor can make a 20% contribution based on the amount of the net Schedule C income.  Combined with the elective deferral, you cannot exceed $61,000, or $67,500 if you are age 50 or older for 2022. The employer contribution can only be made using pretax funds.

The primary distinction of the sole proprietor (or single member LLC) vs. a multi-member LLC or corporation is the percentage used in the profit-sharing calculation. The latter uses 25% instead of 20%, meaning they can reach the maximum with less earnings.

An Example

George, a 45 year old sole proprietor earns $100,000 of net income.  Because he is under age 50, he may contribute $20,500 as the employee, plus an additional $20,000 as the employer (20% of $100,000) for a total of $40,500. If instead George had a corporation, he would be able to contribute $25,000 (25% of $100,000) as the employer, a $5,000 increase.

Solo 401(k) Contribution Deadline – Sole Proprietor

A sole proprietorship reports its income on a Schedule C.  As a result, the IRS understands that a small business, operating as a sole proprietor, would generally not be able to determine their net Schedule C amount by December 31.  This is because most small businesses are still generating sales or revenues up until the end of the year and do not have the time to sit down with a tax professional and calculate available deductions, credits, etc. before the end of the year.

Accordingly, the IRS allows a sole proprietorship that has adopted a Solo 401(k) plan to make both employee deferral and/or employer profit sharing contributions up until April 15 of the following taxable year. If an extension is requested, you have until October 15 to make the contribution (or until you file your 1040).

On the other hand, if you have a corporation, the employee deferral must be made by December 31. You still have until your corporation files its 1120 or 1120S return to make the profit-sharing contribution.

Conclusion

Setting up a Solo 401(k) plan may end up being the best non-business decision for many sole proprietors.  After all, you need to be proactive when it comes to saving for retirement. A better understanding of the contribution rules will go a long way deciding your financial future. Plus, if you understand how they work, you can be better informed about choosing the right type of entity for your business.

Bear in mind the eligibility requirements of the plan. If you have non-owner full-time employees, you must look at a different type of plan. However, so long as you meet the requirements, take full advantage as save as much as you can for the future.