Small Business Owners: This Could Be Your Best Retirement Plan Option
Have you procrastinated about setting up a tax-advantaged retirement plan for your small business? If the answer is yes, you are not alone.
Still, this is not a good situation. You are paying income taxes that could easily be avoided. So consider setting up a plan to position yourself for future tax savings.
For owners of profitable one-person business operations, a relatively new retirement plan alternative is the solo 401(k).
You may also see the solo 401(k) called a “mini-401(k),” a “uni-401(k),” a “one-participant 401(k),” an “individual 401(k),” and so on.
All these terms are meant to describe a 401(k) plan that covers only the business owner and that is therefore exempt from the nasty non-discrimination and coverage rules that afflict multi-participant 401(k) plans. For this article, we will stick with the solo 401(k) nomenclature.
The main solo 401(k) advantage is potentially much larger annual deductible contributions to the owner’s account—that is, your account. Good!
This article explains when a solo 401(k) might be your best tax-favored retirement plan option. Here goes.
Solo 401(k) Account Contributions
With a solo 401(k), annual deductible contributions to the business owner’s account can be composed of two different parts.
First Part: Elective Deferral Contributions
For 2020, you can contribute to your solo 401(k) account up to $19,500 of
your corporate salary if you are employed by your own C or S corporation, or
your net self-employment income if you operate as a sole proprietor or as a single-member LLC that’s treated as a sole proprietorship for tax purposes.
The contribution limit is $26,000 if you will be 50 or older as of December 31, 2020. The $26,000 figure includes an extra $6,500 catch-up contribution allowed for older 401(k) plan participants.
This first part, called an “elective deferral contribution,” is made by you as the covered employee or business owner.1
With a corporate solo 401(k), your elective deferral contribution is funded with salary reduction amounts withheld from your company paychecks and contributed to your account.
With a solo 401(k) set up for a sole proprietorship or a single-member LLC, you simply pay the elective deferral contribution amount into your account.
Second Part: Employer Contributions
On top of your elective deferral contribution, the solo 401(k) arrangement permits an additional contribution of up to 25 percent of your corporate salary or 20 percent of your net self-employment income.
This additional pay-in is called an “employer contribution.” For purposes of calculating the employer contribution, your compensation or net self-employment income is not reduced by your elective deferral contribution.2
With a corporate plan, your corporation makes the employer contribution on your behalf.
With a plan set up for a sole proprietorship or a single-member LLC, you are effectively treated as your own employer. Therefore, you make the employer contribution on your own behalf.3
Combined Contribution Limits
For 2020, the combined elective deferral and employer contributions cannot exceed
$57,000 (or $63,500 if you will be age 50 or older as of December 31, 20204), or
100 percent of your corporate salary or net self-employment income.
For purposes of the second limitation, net self-employment income equals the net profit shown on Schedule C, E, or F for the business in question, minus the deduction for 50 percent of self-employment tax attributable to that business.5
Key point. Traditional defined contribution arrangements, such as SEPs (simplified employee pensions), Keogh plans, and profit-sharing plans, are subject to a $57,000 contribution cap for 2020, regardless of your age.6
Some Illustrative Examples
To see how elective deferral and employer contributions can add up to big numbers, consider the following examples.
Example 1: Corporate Solo 401(k) Plan
Lisa, age 40, is the only employee of her corporation (it makes no difference if the corporation is a C or an S corporation).
In 2020, the corporation pays Lisa an $80,000 salary.
The maximum deductible contribution to a solo 401(k) plan set up for Lisa’s benefit is $39,500. That amount is composed of
Lisa’s $19,500 elective deferral contribution, which reduces her taxable salary to $60,500, plus
a $20,000 employer contribution made by the corporation (25 percent x $80,000 salary), which has no effect on her taxable salary.
The $39,500 amount is well above the $20,000 contribution maximum that would apply with a traditional corporate defined contribution plan (25 percent x $80,000). The $19,500 difference is due to the solo 401(k) elective deferral contribution privilege.
Variation. Now assume Lisa will be age 50 or older as of December 31, 2020.
In this variation, the maximum contribution to Lisa’s solo 401(k) account is $46,000, which consists of
a $26,000 elective deferral contribution (including the $6,500 extra “catch-up” contribution), plus
a $20,000 employer contribution (25 percent x $80,000).
That’s much more than the $20,000 contribution maximum that would apply with a traditional corporate defined contribution plan (25 percent x $80,000). The $26,000 difference is due to the solo 401(k) elective deferral contribution privilege.
Example 2: Self-Employed Solo 401(k) Plan
Larry, age 40, operates his cable installation, maintenance, and repair business as a sole proprietorship (or as a single-member LLC treated as a sole proprietorship for tax purposes).
In 2020, Larry has net self-employment income of $80,000 (after subtracting 50 percent of his self-employment tax bill).
The maximum deductible contribution to a solo 401(k) plan set up for Larry’s benefit is $35,500. That amount is composed of
a $19,500 elective deferral contribution, plus
a $16,000 employer contribution (20 percent x $80,000 of self-employment income).
The $35,500 amount is well above the $16,000 contribution maximum that would apply with a traditional self-employed plan set up for Larry’s benefit (20 percent x $80,000). The $19,500 difference is due to the solo 401(k) elective deferral contribution privilege.
Variation. Now assume Larry will be age 50 or older as of December 31, 2020.
In this variation, the maximum contribution to Larry’s solo 401(k) account is $42,000, which consists of
a $26,000 elective deferral contribution (including the $6,500 extra “catch-up” contribution), plus
a $16,000 employer contribution (20 percent x $80,000).
That’s much more than the $16,000 contribution maximum that would apply with a traditional self-employed defined contribution plan (20 percent x $80,000). The $26,000 difference is due to the solo 401(k) elective deferral contribution privilege.
Solo 401(k) Advantage Shrinks at Higher Income Levels Due to Dollar Cap
Say you make more than the $80,000 stipulated in the preceding examples. Good! You can contribute larger amounts to your solo 401(k) account, up to the applicable dollar cap.7
If you are under age 50, the dollar cap on combined elective deferral and employer contributions is $57,000 for 2020.
If you will be age 50 or older as of December 31, 2020, the cap for 2020 is $63,500, thanks to the extra $6,500 catch-up contribution allowed for older participants.
Remember. Combined elective deferral and employer contributions also cannot exceed 100 percent of your corporate salary or net self-employment income.
The following examples illustrate the impact of the dollar cap.
Example 3: Cap for Higher-Income Self-Employed Owner
Zelda is 45 years old and operates her business as a sole proprietorship (or as a single-member LLC treated as a sole proprietorship for tax purposes).
In 2020, she has $187,500 of net self-employment income (after subtracting 50 percent of her self-employment tax bill).
She can contribute up to $57,000 to her solo 401(k) account. The $57,000 amount is composed of
a $19,500 elective deferral contribution plus
a $37,500 employer contribution (20 percent x $187,500 of self-employment income).
Compare the $57,000 amount with the $37,500 maximum allowable contribution to a traditional self-employed defined contribution plan (20 percent x $187,500). The solo 401(k) delivers a $19,500 advantage, thanks to the elective deferral contribution privilege.
Variation. Now assume Zelda’s 2020 net self-employment income is $285,000 (after subtracting 50 percent of her self-employment tax bill).
She can contribute up to $57,000 to her solo 401(k) account. The $57,000 amount is solely attributable to a $57,000 employer contribution (20 percent x $285,000).
But Zelda could contribute the same $57,000 to a traditional self-employed defined contribution plan (20 percent x $285,000).
In this case, the solo 401(k) does not allow a larger contribution. So a SEP may be a better choice, because a SEP is easier and cheaper to operate.
Example 4: Cap for Older, Higher-Income Self-Employed Owner
Zed is 51 years old with 2020 net self-employment income of $285,000 (after subtracting 50 percent of his self-employment tax bill).
Zed can contribute up to $63,500 to his solo 401(k) account. The $63,500 amount is composed of
a $6,500 elective deferral contribution, plus
a $57,000 employer contribution (20 percent x $285,000 of self-employment income).
Zed could contribute only $57,000 to a traditional self-employed defined contribution plan such as a SEP (20 percent x $285,000). In this case, the solo 401(k) offers a $6,500 advantage, thanks to the catch-up elective deferral contribution privilege for those age 50 or older.
Dollar Cap Summary Statement
The impact of the dollar caps on solo 401(k) contributions and contributions to traditional defined contribution plans (such as SEPs) can be summarized as follows.
When you are under age 50 and operate as a sole proprietorship or a single-member LLC, the $57,000 cap for 2020 causes the solo 401(k) advantage over traditional self-employed defined contribution plans to shrink and eventually disappear between net self-employment income of $187,500 and $285,000. See Example 3.
When you are employed by your own corporation, the $57,000 cap for 2020 causes the solo 401(k) advantage over traditional corporate defined contribution plans to shrink and eventually disappear between salary income of $150,000 and $228,000.
When you are age 50 or older, the solo 401(k) will always permit larger deductible contributions than a traditional defined contribution plan.
That’s because the solo 401(k) cap is increased by the $6,500 (for 2020) additional catch-up elective deferral contribution deal. As a result, the 2020 solo 401(k) cap for folks who are 50 and older is $63,500 versus only $57,000 for a traditional defined contribution plan. (See Example 4.)
Solo 401(k) Mechanics
Five basic steps are required to set up and operate a solo 401(k) plan.
Step 1. If you have an existing retirement plan, discontinue it before establishing the new solo 401(k). Consult a competent retirement plan professional about exactly how to close down the existing plan.
Step 2. Establish your new solo 401(k) by the end of the tax year for which the initial deductible contributions will be made.8 To make a valid elective deferral contribution for that year, the plan must exist before you are deemed to have earned the related self-employment income or corporate salary. For a sole proprietorship or SMLLC business that uses the calendar year for taxes, the plan must be established by no later than December 31 of the year in question, because self-employment income is deemed to be earned on December 31.9 A corporate plan must be established before the salary used to fund elective deferral contributions has been earned.
Step 3. You must make a written election to designate the amount of your elective deferral contribution for the year before the related self-employment income or corporate salary is earned.
For a sole proprietorship or SMLLC that uses the calendar year for taxes, you must make the election by no later than December 31 of the year in question, because self-employment income is deemed to be earned on that date.10 For a corporate plan, you must make the election before the salary to be contributed via the elective deferral has been earned.
Step 4. The elective deferral contribution for the year must be deposited to your solo 401(k) account. For a sole proprietorship or SMLLC, the deadline for making the contribution is as soon as is reasonably possible after you have earned the related self-employment income. For a business that uses the calendar year for taxes, self-employment income is deemed to be earned on December 31, so you should deposit the elective deferral contribution into your account as soon as you can in January of the following year.
For a corporate plan, the elective deferral contribution must be withheld from your salary and contributed to your account as soon as is reasonably possible—but no more than 15 business days after withholding occurs.11
Step 5. Finally, the employer contribution for the year must be made. For a sole proprietorship or SMLLC that uses the calendar year for taxes, you can make the employer contribution as late as the extended due date of your Form 1040 for that year.12 For a corporate plan, the employer contribution can be made as late as the due date, including any extension, of your corporation’s Form 1120 or Form 1120S for that year.13
Planning note. The newly enacted SECURE Act allows, for 2020 and later years, retroactive plan adoption—but that new rule does not allow retroactive “elective” deferrals.
Solo 401(k) Pros
For one-person-business owners who hate to leave tax breaks on the table, the solo 401(k) is a pretty sweet deal because it usually allows much larger annual deductible contributions than you could make to a traditional defined contribution plan (SEP, Keogh, or profit-sharing plan).
Also, the solo 401(k) alternative does not require uncomfortably large contributions for years when cash is tight. You can always decide to contribute less than the maximum or even nothing at all.
You can borrow from your solo 401(k) account (assuming the plan document so permits, which you should insist on). The maximum loan amount is 50 percent of the vested account balance or $50,000, whichever is less.
In contrast, you cannot borrow from a SEP account or SIMPLE-IRA. These accounts are treated as IRAs, and borrowing from IRAs is prohibited.
Solo 401(k) Cons
You should not attempt to set up and operate a solo 401(k) plan without professional assistance.
Up-front paperwork and some ongoing administrative effort will be required, including adopting a written plan document and arranging for how and when elective deferral contributions will be collected and paid into your account.
Fortunately, you can find a number of outfits, including some large brokerage firms, that are ready and willing to handle solo 401(k) plans.
Employees
If your business has employees, the tax rules may require 401(k) contributions for those workers. If so, you obviously do not have a solo 401(k) anymore. Instead, you have a multi-participant plan with all the resulting complications.
But you can exclude employees who are under age 21 and those who have not worked at least 1,000 hours during any 12-month period.14 You can take advantage of this exclusion rule to employ youngsters and part-time workers while effectively operating a solo 401(k) that benefits only you. Heartless and cruel, to be sure, but business is business.
500-hour rule in 2021. The newly enacted SECURE Act enables part-time employees who fail the 1,000-hour test—but who worked at least 500 hours per year with the employer for at least three consecutive years, and who meet the age 21 requirement by the end of the three-consecutive-year period—to make elective deferrals. The new law does not require employer contributions for this group.
FICA Tax
With a corporate solo 401(k), FICA tax is owed on your elective deferral contributions, because they are considered additional salary for FICA tax purposes.15 But the elective deferral contributions will still reduce your salary for income tax purposes and thereby lower your income tax bill.
Employer contributions made by your corporation are exempt from FICA tax.16 Therefore, with a corporate plan, making larger employer contributions and smaller elective deferral contributions may be advisable.
Once the solo 401(k) account balance exceeds $250,000, you must file Form 5500-EZ (Annual Return of One-Participant Retirement Plan) annually.
Takeaways
For a one-person business, the solo 401(k) may be your best retirement plan option if
you want to make larger annual deductible contributions to a tax-deferred retirement account, and
you have substantial annual salary or self-employment income from the business in question, but not so much that you are adversely affected by the dollar caps that apply to solo 401(k) contributions.
If the dollar caps are an issue, evaluate the defined benefit pension plan. It can enable much larger contributions to your retirement plan.
When the dollar caps are not an issue, you usually win with the solo 401(k) deal. And you always win (except compared with the defined benefit plan) when you are age 50 and older and can take advantage of the additional catch-up elective deferral contributions.
1 IRC Sections 402(g) 2018; 414(v); 415(c)(1); IRS Notice 2019-59.
5 IRC Sections 401(c)(2); 402(h)(2) 2018; 404(h); 408(k)(7)(B) 2018; 414(s); 415(c)(3)(B).
6 IRC Section 415(c)(1)(A); IRS Notice 2019-59.
7 IRC Sections 402(g)(1) 2018; 414(v); 415(c)(1)(A); IRS Notice 2019-59.
8 IRC Section 404(a)(3)(A)(i).
9 IRS Reg. Section 1.401(k)-1(a)(6).
10 IRS Reg. Section 1.401(k)-1(a)(6).
11 DOL Reg. Section 2510.3-102(b).