Solo 401k plans have many aliases: solo-k, uni-k, and one-participant-k, among others. Whatever you want to call it, the retirement plan is one of my very favorite for small business owners without eligible participants. They’re easy to set up, inexpensive to operate, and simple to maintain.
One of the few downsides of solo 401k’s is that they do have one murky intricacy: determining the maximum amount you can contribute in a given year.
This post will cover how to calculate solo 401k contribution limits. We’ll cover the contribution calculations, the deadlines, and everything else you need to know about the accounts.
So What Is a Solo 401(k), Exactly?
One of the big misunderstandings about solo 401k’s is that they’re a “special” type of retirement plan by design. They’re not.
With all qualified retirement plans (401k, cash balance, defined benefit, etc.), the IRS affords us some pretty neat tax advantages in order to incentivize us to save for our own retirement. In the case of 401k plans, these tax advantages apply to both the business operating the plan and it’s participants.
In order to prevent businesses from structuring 401k plans that benefit ownership & management (and not rank and file employees), 401k plans are usually required to undergo compliance testing each year. If the plan is considered “top heavy”, where too great a portion of the contributions are made on behalf of executives, ownership is compelled to deposit additional funds on behalf of everyone else.
So, in the eyes of the IRS, businesses may take advantage of a wonderful tax saving opportunity, but only if it’s beneficial all the participants.
A solo 401k plan is just like any other 401k plan. But since there are no employees in the plan, there’s no compliance testing required. You can establish a plan for free at any major brokerage firm, using their boilerplate materials and plan document.
Solo = No Eligible Employees
Just like traditional 401k plans, solo 401k’s are required to have a plan document that describes how the plan is to be operated. Eligibility requirements are included in this document. So long as you don’t have any employees who meet the eligibility requirements in your plan document, you can continue contributing to a solo 401k plan. If you do, you’ll need to either “upgrade” to a traditional 401k, or dissolve the plan.
While you have some discretion over the eligibility requirements, there are some minimum standards your plan must meet. Employees must become eligible if they work 1,000 or more hours per year, are at least 21 years old, and have at least one year of service. Plan documents may also exclude certain union employees and nonresident aliens. Fail any of these three, and a plan document may exclude them from eligibility if you choose.
You may structure a plan to be more generous than these requirements, though. You could structure a plan with an hours requirement of 500, an age requirement of 18, and tenure requirement of six months. So long as your plan’s eligibility standards are not more restrictive than the minimums, you should be in good shape. Just remember that your plan document governs all. Whatever you choose, you must stick to.
No W-2 Income? No Problem!
One way to get around hiring eligible employees is to hire contractors in a 1099 capacity, as opposed to full on W-2 employees. This might be a good alternative, but keep in mind that the IRS has strict definitions of who should be considered a W-2 employee and who should be considered a contractor.
Before circumventing W-2 employees, make sure you’re not bending the IRS interpretation. This is a hot button item under audit, so be warned if you do decide to stretch the rules.
What If I Have a Solo 401(k) But Want To Hire Employees?
If you think you might want to hire employees in the next year or two, the solo 401(k) might not be for you. As soon as you have employees who meet the eligibility requirements in your plan document, you must include them in the plan (or risk facing the wrath of the department of labor and/or the IRS).
Now, this doesn’t mean that your solo 401(k) evaporates or turns into a pumpkin if you hire someone. It only means that you’ll have to perform the annual non-discrimination testing and jump through other hoops once you have eligible employees in the plan.
One of the solo 401(k)’s main benefits is it’s simplicity and low administration costs. Add the wrinkle of compliance testing and all of a sudden administration isn’t so simple. When this happens other small business retirement plans (think SEP-IRA or SIMPLE IRA) are often more appealing. Fortunately, terminating your solo 401(k) and starting a SEP or SIMPLE is relatively easy.
Other Eligibility Issues
The bar for being eligible to contribute to a solo 401k is actually pretty low: as long as you have self-employment income you may contribute to a solo 401k. This could be work as a 1099 independent contractor, or any income as a sole proprietorship, partnership, or LLC.
Solo 401k plans are most often used by sole prop’s and single member LLCs. Since having eligible employees prevents businesses from using them, most people who do have relatively small companies.
Even so, solo 401(k)s can also be used in partnerships, multi member LLCs, S-corporations, and C-corporations as long as there are no qualifying employees.
How To Calculate Solo 401k Contribution Limits
This is where many business owners get tripped up. The exact amount you’re allowed to contribute to a solo 401(k) plan depends on a few different factors. Mainly, your business entity and net income from self-employment.
When you maintain a 401(k) plan (solo or other), you technically wear two hats. One as the business owner and sponsor of the plan, the other as an employee. As an employee, you’re entitled to defer up to 100% of your compensation (or “earned income) up to $19,000 to a 401(k) plan in 2019. This number creeps up every few years to keep pace with inflation. If you’re 50 or older, you can also make “catch up” contributions of $6,000, totaling $24,000 in elective deferrals.
As an employer, you’re also entitled to make profit sharing contributions to your plan. Again, this is where the structure of a solo 401(k) plan comes in handy. If you have eligible employees, profit sharing contributions must be made to all participants, based on age/tenure/comp/etc. as specified in your plan document. With no employees you’re free to make profit sharing contributions for yourself only, up the IRS limits.
These limits depend on your business entity. They’re limited to 25% of your compensation for:
- Multi-member LLCs
Profit sharing contributions for sole proprietorships and single member LLCs are slightly more complex. The IRS states in code 401(a)(3) that employer contributions are limited to to 25% of the business owner’s income that’s subject to self-employment tax. And remember – because sole props and single member LLCs are entitled to deduct half of their total self employment tax. Thus, not all self-employment income will be subject to self-employment tax.
To sort all this out, sole proprietors and single member LLC owners are required to perform an additional calculation. The IRS has a step-by-step worksheet for this calculation in publication 560, found here, but effectively the math works out to about 20% of earned income instead of 25%. Bankrate.com also has a decent calculator that may be helpful.
Between your employee deferrals and employer profit sharing contributions, your total contributions in 2019 may not exceed $56,000 if you’re under 50 years old. If you’ve reached 50, your aggregate limit rises to $62,000 with the $6,000 of catch up contributions.
Keep in mind that this limit impacts contributions to other 401k plans too, if you have multiple businesses. You may make elective deferrals of up to $19,000 ($25,000 if you’re over 50) across all the 401k plans you participate in. There’s not limit the number of plans you make profit sharing contributions to, so long as they’re unrelated plans & entities and you stay under the $56,000 limit.
Although you’re not able operate a solo 401(k) while having eligible employees, spouse earn an exception in the eyes of the DOL and IRS. As long as your spouse is your only employee, you may continue using a solo 401(k) without jeopardizing your plan’s status. Your spouse can even contribute to the plan too, if they wish, up the annual limits. This can be extremely convenient, as could potentially boost your household contribution limit to $112,000 per year – without any compliance testing!
Implementing & Maintaining A Solo 401(k) Plan
Implementing a solo 401(k) plan is pretty straight forward, and most brokerage firms offer them at very low annual costs. If you’re establishing a brand new plan, it must be done by December 31st of the tax year you’d like to contribute for. Fortunately, as long as you establish the plan by that date, you have some flexibility over when your contributions are actually deposited.
Elective deferrals may be deposited any time before your tax filing deadline. This is usually April 15th for sole prop’s, single member LLCs, and C-Corps, and March 15th for multi-member LLCs, partnerships, and S-Corps. This deadline includes extensions too, which could push your deadline out another six months to September 15th or October 15th.
Although your contributions may be deposited any time before your tax filing deadline, they need to be reported on your W-2 (in the case of an S-Corp or C-Corp) by January 31st. Since your employee deferrals will show up as a deduction from your wages in box 12, this notifies the IRS that you’re electing to defer a portion of your comp, and will have the deposit made by your tax filing deadline. Logistically, best practice is to let your bookkeeper or accountant know that you’d like to make a contribution. They can then handle the reporting for you on your books and payroll files.
As for profit sharing contributions, they may be made any time before your tax filing deadline, plus extensions. You’ll claim the deduction for the contribution on either your business or personal return.
Once opened, solo 401(k)s are pretty simple to maintain. Plans with assets over $250,000 must file form 5500 SF (short form) with the department of labor. The standard for 5500 can be cumbersome, but the short form is considerably less so. There are no annual 5500 filing requirements if the total balance in your solo 401(k) is less than $250,000.
The contribution limits to solo 401(k)s can be tricky, so here are a few examples:
Sole Proprietorship or Single Member LLC
Imagine that Stephanie, 35 years old, is a sole proprietor and has $125,000 in self employment income on Schedule C of her tax return. Stephanie may make $19,000 in employee deferrals. She may also make a profit sharing contribution of 25% of her adjusted earned income: $92,935. Adjusted earned income is calculated as: (Self-employment compensation – deductible portion of self-employment tax) / (1 + contribution percentage).
($125,000 – $8,831) / (1 + 25%) = $92,935. 25% of this amount works out to $23,233. Stephanie’s total contribution between elective deferrals and profit sharing contributions would be $42,233.
S-Corp or C-Corp
Let’s say Kyle, who is 58 years old, earned $75,000 in W-2 wages from his S-corp. He deferred $19,000 in regular deferrals and $6,000 in catch up contributions.
His business could contribute up to $18,750 in profit sharing contributions ($75,000 * 25%), totaling $43,750 in annual contributions. Note that Kyle’s profit sharing limit is based on $75,000 in W-2 compensation.
If Kyle’s W-2 income were $275,000, he could still make the $19,000 employee deferral and $6,000 catch up contribution, but his profit sharing contribution would be limited to $37,000 based on the aggregate limit. This total contribution would be $19,000 + $6,000 + $37,000 = $62,000.
Partnership or Multi Member LLC
Now let’s say that Kyle converts his business from an S-corp to a multi member LLC, and earns $65,000. He has several business partners but no employees.
He may still defer $18,000 as an employee and $6,000 as a catch up contribution. But since he no longer has W-2 wages, he bases his profit sharing contribution on the K-1 income attributable to self-employment earnings. His total contribution limit would be $19,000 + $6,000 + $16,250 ($65,000 * 25%) = $41,250.