Sole proprietors who maintain solo 401(k)s are able to capitalize on a number of benefits — from increased contribution limits to relatively minimal compliance requirements. In fact, compliance requirements are so minimal that business owners often forget about them until there’s a problem. For those business clients, it’s time to take notice. The IRS has recently announced that solo 401(k)s will be the focus of increased audit efforts — meaning that if your business client contributes to a solo 401(k), it’s time to review their status to determine whether everything is in order.
A solo 401(k) is a 401(k) plan that covers only the business owner (the plan can also cover a spouse). In most ways, the solo 401(k) operates in the same manner as a traditional 401(k) —contributions are made on a pretax basis and subject to ordinary income taxes when withdrawn in retirement.
One key advantage of a solo 401(k) plan is that the employer-participant isn’t required to perform nondiscrimination testing because there are no employees, non-highly compensated or otherwise. Filing requirements are also minimal — if the plan’s assets are at least $250,000 at year-end, the plan is required to file an annual report on Form 5500-EZ.
Solo 401(k)s also allow the owner to make larger contributions each year. In 2021, the owner-employee can contribute up to $19,500 ($26,000 if the participant is 50 or older) in pretax dollars per year as an employee. The business owner is also permitted to contribute up to $38,500 to the plan as employer (for a total employer-employee contribution limit of $58,000 in 2021, or $64,500 for those aged 50 and up).
However, employer contributions are also generally limited to 25% of compensation, up to the overall maximum of $58,000 (or $64,500, considering catch-up contributions).
Sponsors of solo 401(k)s are not permitted to have any employees. Thus, business owners who recently hired employees will no longer qualify for the solo 401(k) structure — meaning that they’ll be subject to the traditional nondiscrimination requirements that apply generally to 401(k) plans unless they satisfy certain safe harbor criteria.