A Solo 401(k) (also known as a Self Employed 401(k) or Individual 401(k)) is a 401(k) qualified retirement plan for Americans that was designed specifically for employers with no full-time employees other than the business owner(s) and their spouse(s). The general 401(k) plan gives employees an incentive to save for retirement by allowing them to designate funds as 401(k) funds and thus not have to pay taxes on them until the employee reaches retirement age. In this plan, both the employee and his/her employer may make contributions to the plan. The Solo 401(k) is unique because it only covers the business owner(s) and their spouse(s), thus, not subjecting the 401(k) plan to the complex ERISA (Employee Retirement Income Security Act of 1974) rules, which sets minimum standards for employer pension plans with non-owner employees. Self-employed workers who qualify for the Solo 401(k) can receive the same tax benefits as in a general 401(k) plan, but without the employer being subject to the complexities of ERISA.
Prior to 2001, self-employed workers were limited to a profit sharing retirement plan that did not include any employee deferral options in contrast to a multiple employer 401(k) Plan. There existed a retirement platform unique to self-employed workers, the SEP IRA and the Keogh plan, but it lacked many of the benefits of the typical corporate 401(k) platform, such as employee deferral. Congress remedied this situation in 2001 with the passing of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA).[1] Although EGTRRA was primarily known for its tax reductions, it also amended tax law to allow for self-employed individuals to access a 401(k) style retirement platform.[2] This platform became popularly known as the Solo 401(k).
Qualifications
In order to qualify for a Solo 401(k), an individual must claim some self-employed income. However, he/she does not need to work full-time in a self-employed capacity. A common example of part-time self-employed income is an individual who works for an employer, but also does a little consulting on the side. The consulting income would be considered self-employed income, thereby rendering the individual's business eligible for adopting a Solo 401(k).[3] A Solo 401(K) Plan can be adopted by any self-employed business, including a sole proprietorship, limited liability company, partnership, C-Corporation, S-Corporation etc.
The business adopting the Solo 401(k) Plan must also not employ any full-time employees that are eligible to participate in the plan, other than the business partners and their spouses. A full-time employee is generally defined as one who works at least 1,000 hours per year for his/her employer.[4] Certain employees may be excluded from plan eligibility, such as those under age 21,[5] non-resident aliens, and union members for which retirement benefits were the subject of a collective bargaining agreement.[6]
Types
The two basic types of Solo 401(k) plans are brokerage based and self-directed, also known as a "checkbook control" Solo 401(k).[7] The type of plan is based on the plan documents. The basic plan documents state and control the operations of the plan, and the adoption agreement offers the employer the ability to customize the plan based on the options available in the basic plan. In other words, the options available to an adopting employer and its plan participant(s) would be based on the options available in the basic plan document and plan adoption agreement. A plan sponsor - the company offering the plan to the employer - would typically offer either an individually designed Solo 401(k) Plan or a prototype plan.
Brokerage-based plan documents usually limit the available investment options and offer market-based assets, such as stocks and mutual funds, while self-directed plan documents generally offer more investment options and often allow for alternative assets, such as real estate and private business, as well as include a loan feature and Roth deferrals. Investors typically choose between the two plans based on their investment goals, asset preference, fee schedules, and desired level of control.[8]
While a brokerage-based Solo 401(k) plan and self-directed Solo 401(k) plan would both be considered a qualified retirement plan, the options available under these plans as per the Plan Adoption Agreement generally differ in a number of ways:
The self-directed Solo 401(k) Plan typically allows for greater investment options than a brokerage-based Solo 401(k) Plan, including real estate, precious metals, private loans, cryptocurrencies, and private business investments. The only investments not allowed by law are "collectibles" as defined in §408(m) of the IRC.[9]
Unlike a brokerage-based Solo 401(k) Plan, a self-directed Solo 401(k) Plan will typically offer a loan feature, which will allow the plan participant to borrow the lesser of $50,000 or 50% of their account value and use the loan for any purpose. If a Solo 401(k) plan allows loans, the participant can borrow any amount that is in their designated Roth account, including amounts that rolled over into that account as an in-plan Roth rollover.
Unlike a brokerage-based Solo 401K Plan, a self-directed Solo 401(k) Plan contains a built in Roth sub-account which can be contributed to without any income restrictions. In addition, most brokerage Solo 401K Plans do not allow for the conversion of a traditional 401(k) or 403(b) account to a Roth subaccount.
The self-directed Solo 401(k) Plan will allow the adopting employer to open the plan account at most local banks in order to obtain check writing ability as well as have a brokerage account.
Contribution limits
The contribution limits for the Solo 401(k) are the same as a standard ERISA 401(k). They are broken down into a profit sharing contribution which comes from the employer, and a salary deferral contribution which comes from the employee.[10] However, due to the fact that in a Solo 401(k) the plan holder is acting both as employer and employee, the actual percentages assume a more meaningful role. If the plan holder is filing as a Sole Proprietor or Single Member LLC (which is true in most cases), then the limit is capped at 20% of the self-employed income plus $19,000 for 2019, a $500 increase from 2018. Internal Revenue Code Section 401(a)(3) states that the amount of employer contributions is limited to 25 percent of the entity's income subject to self-employment tax. Schedule C sole-proprietors must do an added calculation starting with earned income to determine their maximum contribution, which, in effect, brings the maximum 25% of compensation limit down to 20% of earned income. A step-by-step worksheet for this calculation can be found in IRS Publication 560.[11]
If the plan holder is 50 years or older, then he/she may contribute an additional $6,000 for 2019, the same as 2017, on top of the standard contribution. This additional contribution is often referred to as a catch-up contribution. Note this additional catch-up contribution does not apply to the SEP IRA. Calculating one's maximum annual solo 401(k) contribution limitation, including employee deferrals and profit sharing contributions, is based on self-employment income or W-2 income earned by the plan participant and the adopting employer's established legal entity (sole proprietorship vs. "C" corporation). In other words, in the case of a "C" or "S" corporation, the employee deferral and profit sharing contribution is based on the individual plan participant's W-2 amount.
In both cases, the IRS has declared an upper limit for total employer and employee contributions to a plan —the IRS Section 415(c) limit— which may not be exceeded. As of 2019, this upper limit is $56,000 for those under 50, $1,000 more than 2018, and $62,000 for those 50 and older, $1,000 more than 2018.[12] If an individual is eligible to contribute to the 401(k) plans of multiple unrelated employers, employee deferral contributions can be made to each plan but cannot exceed the annual limitation when taking contributions to all plans in the aggregate. The maximum total contribution limit is per qualified plan. as per this example from IRS publication "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits" "Example 1: Greg, 46, is employed by an employer with a 401(k) plan and he also works as an independent contractor for an unrelated business. Greg sets up a solo 401(k) plan for his independent contracting business. Greg contributes the maximum amount to his employer's 401(k) plan for 2019, $19,000. Greg would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $19,000. He has enough earned income from his business to contribute the overall maximum for the year, $56,000. Greg can make an after-tax contribution of $56,000 to his solo 401(k) plan. This limit is not reduced by the elective deferrals under his employer's plan because the limit on annual additions applies to each plan separately."[13]
The employee deferral contribution can be made in both pre-tax, after-tax or Roth, so long as the plan documents allow for it. The employer profit sharing contributions must be made in pre-tax form.
Thanks to the American Taxpayer Relief Act of 2012, if the plan documents allow it, any vested plan balance, including Solo 401(k) plan employee deferrals and employer profit sharing contributions, as well as earnings, can be rolled over to a designated Roth account, even if these amounts can't be distributed to the participant. The purpose behind the relaxation of the in-plan Roth rollover rules is to encourage plan participants to do Roth conversions and thereby increase the amount of current tax revenues collected by the Treasury. If the Solo 401(k) plan documents allows them, an in-plan Roth rollover can be done as either a direct or 60-day rollover. For a direct rollover, the plan trustee transfers the non-Roth amount to a designated Roth account in the same plan. In-plan Roth rollovers of amounts not normally distributable must be accomplished via a direct rollover. For a 60-day rollover, the plan distributes an eligible rollover distribution from the non-Roth account; the participant then deposits all or part of that distribution into a designated Roth account in the same plan within 60 days.
The in-plan Roth rollover is treated as taxable income (fair market value minus the basis in the distribution) and the Roth rollover must be reported in the participant's gross income for the tax year in which is it received. There is no income tax withholding required on an in-plan Roth direct rollover. However, if a distribution is received, the plan must withhold 20% federal income tax on the untaxed amount even if the distribution is rolled over to a designated Roth account within 60 days.
For a sole proprietorship, or an LLC taxed as a sole proprietorship, the deadline for depositing salary deferrals into the Solo 401k, as well as the deadline to fund the profit sharing contribution, is the personal tax filing deadline April 15 (or October 15 if an extension was filed).
For a partnership, or an LLC taxed as a partnership, the deadline for depositing salary deferrals into the Solo 401k, as well as the deadline to fund the profit sharing contribution, is the partnership tax filing date of March 15 (or September 15 if an extension was filed).[11]
Tax implications
The Solo 401(k) is an IRS Qualified Retirement Plan which means that it shares the same tax benefits as other QRPs. A qualified retirement plan is a plan that meets requirements of the Internal Revenue Code and as a result, is eligible to receive certain tax benefits. For a Traditional Solo 401(k), the income contributed into the plan is tax deferred. The concept of tax deferral is premised on the notion that all income and gains generated by the pre-tax retirement account investment would generally flow back into the retirement account tax-free. Instead of paying tax on the returns of a self-directed IRA investment, such as real estate, tax is paid only at a later date, leaving the investment to grow unhindered. For example, if an IRA investor invested $100,000 into a Self-Directed IRA LLC in 2012 and the account earns $10,000 in 2012, the investor would not owe tax on that $10,000 in 2012. Instead, the self-directed IRA investor would be required to pay the taxes when he or she withdraws the money from the IRA, which could be many years later. For example, assuming the IRA investor mentioned above is in a 33% federal income tax bracket, she would have had to pay $3,333 in federal income taxes on the $10,000 earned on the IRA in 2012. That would have left $6,667 in the account. At an 8% annual return, those earnings would go on to produce $533.36 in 2013. However, because IRAs are tax deferred, the self-directed IRA investor is able to earn a return on the full $10,000 rather than the $533.36 she would have had if she had to pay taxes that year. At an 8% annual return, she'd earn $800 in 2013. The primary benefit of tax deferral is that the deferral compounds each year. Tax deferred investments though a self-directed IRA LLC generally help investors generate higher returns. That's because the money that would normally be used for tax payments is instead allowed to remain in the account and earn a return.
Tax responsibility doesn't start until retirement age as the plan holder begins to take out Required Minimum Distributions (RMDs). The tax bracket is determined at the time that the distributions are taken. For a Roth Solo 401(k), the funds go in as post-tax dollars and thus are no longer subject to taxation, assuming the distribution would be treated as a qualified distribution. For a distribution to be qualified, it must occur at least five years after the Roth Solo 401(k) Plan participant established and funded his/her first Roth 401(k) plan account, and the distribution must occur under at least one of the following conditions:
The Roth 401(k) Plan participant is at least age 59.5 when the distribution occurs.
The distributed assets are used toward the purchase, or to build or rebuild a first home for the Roth 401(k) Plan participant or a qualified family member. Qualified family members include the Roth 401(k) Plan participant's spouse, a child of the Roth 401(k) Plan participant and/or of the Roth 401(k) Plan participant's spouse, a grandchild of the Roth 401(k) Plan participant and/or of his or her spouse, a parent or other ancestor of the Roth 401(k) Plan participant and/or of his or her spouse. This is limited to $10,000 per lifetime.
The distribution occurs after the Roth 401(k) Plan participant becomes disabled.
The assets are distributed to the beneficiary of the Roth 401(k) Plan participant after the Roth 401(k) Plan participant's death.
If a plan holder is using his/her Solo 401(k) funds to invest in an active business held through a passthrough entity, such as a limited liability company or partnership, then there is the possibility of Unrelated Business Income Tax (UBIT or UBTI).[14] This is a tax that is levied on tax exempt entities, such as a charity, IRA, or 401(k) Plan, that have invested in an active trade or business unrelated to its exempt purpose. The net profits allocated to the tax-exempt entity from the active trade or business held through a passthrough entity are subject to UBIT on a yearly basis. The UBTI is reported on the IRS Form 990-T. Most investments entered into by retirement plans, however, are not considered active businesses, and therefore are not subject to UBIT.
The tax forms that apply to a Solo 401(k) can vary according to the assets and size of the plan. Here is a listing of the most common:[15]
IRS Form 5500-EZ - Solo 401(k) plans that have assets in excess of $250,000 need to file IRS form 5500-EZ. This filing is for reporting purposes only and does not require any payments.
Form 1040 - If the plan has less than $250K of assets, (which means there is no IRS Form 5500-EZ filing requirement), then employee deferral contributions are reported on their annual income tax return (1040 line 28) as adjusted income for QRP contribution. Employer Profit sharing contributions would be reported on IRS Form 1040, Schedule C for a self-employed individual (and on the corporate tax return for an employer corporation).
Form 1099-R - Form 1099-R needs to be filed when a distribution is taken from the Solo 401(k), or when an In-Plan Roth conversion is performed. The reported distributions will be taxable unless the distributions are after-tax funds.
Form 990-T - If the Solo 401(k) had Unrelated Business Income during the previous year, it must file form 990-T to report and pay the amount of UBIT that is due.
Differences from a SEP IRA
Although both the Solo 401(k) and SEP IRA function as a retirement vehicle for self-employed individuals, the Solo 401(k) offers a number of features not found in the SEP.
It is easier to contribute the maximum amount in a Solo 401(k) because of the Salary Deferral component of $18,500 in 2018, which is not available with a SEP IRA.
A Solo 401(k) Plan includes a $6000 catch-up contribution for plan participants over the age of 50, which is not the case for a SEP IRA.
A Solo 401(k) Plan can offer the owner Roth contributions, even in the case where the owner is otherwise not eligible to contribute to a Roth IRA due to the Roth's annual income limitation.
Unlike an IRA, a special custodian is not required to be used. Most Solo 401(k) Plans can be structured as trustee directed plans, hence, the 401(k) plan account can generally be opened at any local bank and most financial institutions. This allows for faster and more economical transactions.
The Solo 401(k) allows for a personal loan up to $50,000 or 50% account of the plan participant's account value, whatever is less.
The Solo 401(k) is not required to pay UDFI on leveraged real estate, assuming the loan satisfied the rules under Internal Revenue Code Section 514.
Prohibited Transactions can be fixed in a Solo 401(k), while in a SEP IRA a Prohibited Transaction will often lead to the liquidation of the plan.
Unlike a SEP IRA, after tax contributions may be made to Solo 401k plans. The solo 401k after tax contributions can also be converted to Roth solo 401k designated funds. The conversion of after tax funds held in 401k plans such as solo 401k plans came as a result of IRS Notice 2014-54,[16] which was published by the IRS on September 18, 2014.
The after-tax contribution strategy is only available if the plan documents specifically allow for after-tax contributions.
In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code. Periodical employee contributions come directly out of their paychecks, and may be matched by the employer. This legal option is what makes 401(k) plans attractive to employees, and many employers offer this option to their (full-time) workers.
An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with a taxpayer's earned income for the taxpayer's eventual benefit in old age. An individual retirement account is a type of individual retirement arrangement as described in IRS Publication 590, Individual Retirement Arrangements (IRAs). Other arrangements include employer-established benefit trusts and individual retirement annuities, by which a taxpayer purchases an annuity contract or an endowment contract from a life insurance company.
A Roth IRA is an individual retirement account (IRA) under United States law that is generally not taxed upon distribution, provided certain conditions are met. The principal difference between Roth IRAs and most other tax-advantaged retirement plans is that rather than granting a tax reduction for contributions to the retirement plan, qualified withdrawals from the Roth IRA plan are tax-free, and growth in the account is tax-free.
The Economic Growth and Tax Relief Reconciliation Act of 2001 was a major piece of tax legislation passed by the 107th United States Congress and signed by President George W. Bush. It is also known by its abbreviation EGTRRA, and is often referred to as one of the two "Bush tax cuts".
In the United States, a 403(b) plan is a U.S. tax-advantaged retirement savings plan available for public education organizations, some non-profit employers (only Internal Revenue Code 501(c)(3) organizations), cooperative hospital service organizations, and self-employed ministers in the United States. It has tax treatment similar to a 401(k) plan, especially after the Economic Growth and Tax Relief Reconciliation Act of 2001.
A health savings account (HSA) is a tax-advantaged medical savings account available to taxpayers in the United States who are enrolled in a high-deductible health plan (HDHP). The funds contributed to an account are not subject to federal income tax at the time of deposit. Unlike a flexible spending account (FSA), HSA funds roll over and accumulate year to year if they are not spent. HSAs are owned by the individual, which differentiates them from company-owned Health Reimbursement Arrangements (HRA) that are an alternate tax-deductible source of funds paired with either high-deductible health plans or standard health plans.
The 457 plan is a type of nonqualified, tax advantaged deferred-compensation retirement plan that is available for governmental and certain nongovernmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pretax or after-tax (Roth) basis. For the most part, the plan operates similarly to a 401(k) or 403(b) plan with which most people in the US are familiar. The key difference is that unlike with a 401(k) plan, it has no 10% penalty for withdrawal before the age of 55. These 457 plans can also allow independent contractors to participate in the plan, where 401(k) and 403(b) plans cannot.
A retirement plan is a financial arrangement designed to replace employment income upon retirement. These plans may be set up by employers, insurance companies, trade unions, the government, or other institutions. Congress has expressed a desire to encourage responsible retirement planning by granting favorable tax treatment to a wide variety of plans. Federal tax aspects of retirement plans in the United States are based on provisions of the Internal Revenue Code and the plans are regulated by the Department of Labor under the provisions of the Employee Retirement Income Security Act (ERISA).
A Savings Incentive Match Plan for Employees Individual Retirement Account, commonly known by the abbreviation "SIMPLE IRA", is a type of tax-deferred employer-provided retirement plan in the United States that allows employees to set aside money and invest it to grow for retirement. Specifically, it is a type of Individual Retirement Account (IRA) that is set up as an employer-provided plan. It is an employer sponsored plan, like better-known plans such as the 401(k) and 403(b), but offers simpler and less costly administration rules, as it is subject to ERISA and its associated regulations. Like a 401(k) plan, the SIMPLE IRA can be funded with pre-tax salary contributions, but those contributions are still subject to Social Security, Medicare, and Federal Unemployment Tax Act taxes. Contribution limits for SIMPLE plans are lower than for most other types of employer-provided retirement plans as compared to conventional defined contribution plans like Section 402(g), 401(k), 401(a), and 403(b) plans.
A Simplified Employee Pension Individual Retirement Arrangement is a variation of the Individual Retirement Account used in the United States. SEP IRAs are adopted by business owners to provide retirement benefits for themselves and their employees. There are no significant administration costs for a self-employed person with no employees. If the self-employed person does have employees, all employees must receive the same benefits under a SEP plan. Since SEP-IRAs are a type of IRA, funds can be invested the same way as most other IRAs.
A traditional IRA is an individual retirement arrangement (IRA), established in the United States by the Employee Retirement Income Security Act of 1974 (ERISA). Normal IRAs also existed before ERISA.
The Roth 401(k) is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A, and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. Since January 1, 2006, U.S. employers have been allowed to amend their 401(k) plan document to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. The same change in law allowed Roth IRA type contributions to 403(b) retirement plans. The Roth retirement plan provision was enacted as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001.
Deferred compensation is an arrangement in which a portion of an employee's income is paid out at a later date after which the income was earned. Examples of deferred compensation include pensions, retirement plans, and employee stock options. The primary benefit of most deferred compensation is the deferral of tax to the date(s) at which the employee receives the income.
Keogh plans are a type of retirement plan for self-employed people and small businesses in the United States.
A self-directed individual retirement account is an individual retirement account (IRA) which allows alternative investments for retirement savings. Some examples of these alternative investments are real estate, private mortgages, private company stock, oil and gas limited partnerships, precious metals, digital assets, horses and livestock, and intellectual property. The increased investment options available in self-directed IRAs prompted the SEC to issue a public notice in 2011 due an increased risk of fraud in alternative assets.
Required minimum distributions (RMDs) are amounts that U.S. tax law requires one to withdraw a minimum amount annually from traditional IRAs and employer-sponsored retirement plans. In the Internal Revenue Code itself, the precise term is "minimum required distribution". Retirement planners, tax practitioners, and publications of the Internal Revenue Service (IRS) often use the phrase "required minimum distribution".
Pension administration in the United States is the act of performing various types of yearly service on an organizational retirement plan, such as a 401(k), profit sharing plan, defined benefit plan, or cash balance plan. Increasingly, employers are also implementing these plan types in combination arrangements for greater contribution potential, such as the pairing of a cash balance plan with some variety of 401(k). The pension administration ensures that an organizational retirement plan neither discriminates against lower-level employees nor becomes an abusive tax shelter. Stress tests include the average benefits test, average deferral percentage, and minimum coverage. Yearly pension administration work involves filing a Form 5500 with the Internal Revenue Service (IRS). Organizations such as the National Institute of Pension Administrators and the American Society of Pension Professionals and Actuaries offer several professional designations to those who do this work. Pension Administration firms often rely on financial brokers for their business prospects, although they do have other referral sources. Some pension administration firms assign financial advisory work to an internal unit and also accept referrals from an independent broker network. These brokers are often associated with firms like Raymond James, Edward Jones Investments and Morgan Stanley. The brokers may be employees of these firms or independent contractors. The plan assets of the organizational retirement plans in question sometimes reside on a trading platform that the administration firm control. More often, large financial institutions that provide a variety of investment options for plan participants hold the assets. Large firms include Principal Financial Group, John Hancock Insurance, ING Group and Mass Mutual. Pension administrators often coordinate with public accounting firms, as the Employee Retirement Income Security Act of 1974 (ERISA) requires plans with more than one hundred participants to undergo an independent audit each year. For defined benefit plans, the pension administration firm must employ an actuary to certify the plan's present and future benefit liabilities and compliance with IRS minimum funding standards. Pension administration firms with a large block of defined benefit plans often directly employ an actuary. Firms that only work on a small collection of defined benefit plans tend to retain the actuary as an independent contractor. The actuary completes contribution calculations for the plan and provides a Schedule SB so that the administrators may file the yearly Form 5500. Without this Schedule the yearly filing for a defined benefit plan would be incomplete. Other than the IRS, organizational retirement plan operation and maintenance falls under the regulation of the United States Department of Labor.
In the United States, an employer matching program is an employer's potential payment to their 401(k) plan that depends on participating employees' contribution to the plan.
Employer compensation in the United States refers to the cash compensation and benefits that an employee receives in exchange for the service they perform for their employer. Approximately 93% of the working population in the United States are employees earning a salary or wage.
In the United States, Form 1099-R is a variant of Form 1099 used for reporting on distributions from pensions, annuities, retirement or profit sharing plans, IRAs, charitable gift annuities and Insurance Contracts. Form 1099-R is filed for each person who has received a distribution of $10 or more from any of the above.
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