A 401(k) Plan for the Small Business Owner

What Is a Solo 401(k)?

The 401(k) plan has gained popularity among small business owners ever since 2001, when some changes to federal tax law made it a better and more flexible choice for their needs compared with some other retirement savings options. These 401(k) plans are known as “solo 401(k)” plans.

How the Solo 401(k) Works

The solo 401(k) is a retirement savings option for small businesses whose only eligible participants in the plan are the business owners (and their spouses, if they are also employed by the business). It can be a smart way for someone who is a sole proprietor or an independent contractor to set aside a decent-sized nest egg for retirement.

Various financial institutions have their own names for the solo 401(k) plan. The independent 401(k) is one of the most generic. Other examples include:

• Solo 401(k)
• Solo-k
• Uni-k
• One-participant k
• Individual 401(k)
• Self-employed 401(k)

If you are not sure which name your financial service provider uses, ask about the 401(k) plan for small business owners. The Internal Revenue Service (IRS) provides a handy primer on such plans.

Who Is Eligible for Solo 401(k) Plans?

A common misconception about the solo 401(k) is that it can be used only by sole proprietors. In fact, the solo 401(k) plan may be used by any small business, including corporations, limited liability companies (LLCs), and partnerships. The only limitation is that the only eligible plan participants are the business owners (and their spouses, provided they are employed by the business).

A person who works for one company (in which they have no ownership) and participates in its 401(k) can also establish a solo 401(k) for a small business they run on the side, funding it with earnings from that venture. However, the aggregate annual contributions to both plans cannot collectively exceed the IRS-established maximums.

How to Set Up a Solo 401(k) Plan

For small business owners who meet certain requirements, most financial institutions that offer retirement plan products have developed truncated versions of the regular 401(k) plan for use by business owners who want to adopt the solo 401(k). As a result, less complex documentation is needed to establish the plan. Fees may also be relatively low. Make sure to receive the proper documentation from your financial services provider.

As noted above, the solo 401(k) plan may be adopted only by businesses in which the only employees eligible to participate in the plan are the business owners and eligible spouses. For eligibility purposes, a spouse is considered an owner of the business, so if a spouse is employed by the business, you are still eligible to adopt the solo 401(k).

If your business has non-owner employees who are eligible to participate in the plan, your business may not adopt the solo 401(k) plan. Therefore, if you have non-owner employees, they must not meet the eligibility requirements you select for the plan.

Solo 401(k) Eligibility Requirements

Setting the wrong eligibility requirements could result in you being excluded from the plan or non-owner employees being eligible to participate in the plan.

For example, say you elect zero years of service as a requirement to participate, but you have five seasonal employees who work fewer than 1,000 hours each year. These employees would be eligible to participate in the plan because they meet the age and service requirements. Consequently, their eligibility would disqualify your business from being suitable to adopt the solo 401(k) plan. Instead, you could adopt a regular 401(k) plan.

Some solo 401(k) products, by definition, require further exclusions. Before you decide to establish a solo 401(k) plan, be sure to check with your financial services provider regarding its provisions.

Contribution Requirements

You may require an employee to perform one year of service before becoming eligible to make elective-deferral contributions to a 401(k) and two years of service in order to be eligible to receive profit-sharing contributions. However, most solo 401(k) plans will limit the latter requirement to one year.

An employee is considered to have performed one year of service if they work at least 1,000 hours during the year. While you may choose to require fewer than 1,000 hours under a regular qualified plan, most solo 401(k) plans include a hard-coded limit of 1,000 hours.

Solo 401(k) Contribution Limits

There are two components to the solo 401(k) plan: employee elective-deferral contributions and profit-sharing contributions.

Employee Contribution Limits

You may make a salary-deferral contribution of up to 100% of your compensation or the annual limit for the year, whichever is less. For 2024 the limit is $23,000, plus a catch-up contribution of $7,500 for people age 50 or over.

Employer Contribution Limits

In 2024 the business may contribute up to 25% of your compensation (calculations are required in the case of the self-employed) but no more than $69,000. An employee aged 50 or above can still make the above-mentioned $7,500 catch-up contribution.

Other 401(k) Plans

In comparison with other popular retirement plans, the solo 401(k) plan has high contribution limits, which is the key component that attracts owners of small businesses. Some other retirement plans limit the contributions by employers too, or set lower limits on salary-deferred contributions.

The following is a summary of contribution comparisons for the employer plans generally used by small businesses.

Contributions Example

As mentioned earlier, you may make employee elective-deferral contributions of up to 100% of your compensation but no more than the elective-deferral limit for the year. Profit-sharing contributions are limited to 25% of your compensation (or 20% of your modified net profit if your business is a sole proprietorship or partnership). The total solo 401(k) contribution is the employee elective-deferral contribution plus the profit-sharing contribution—up to $69,000 for 2024.

If your business is a corporation, the profit-sharing contribution is based on the W-2 wages you receive. If you receive $70,000 in W-2 wages, for instance, your profit-sharing contribution could be up to $17,500 ($70,000 x 25%). When added to a salary-deferral contribution of $19,000, the total would be $36,500.

If your business is a sole proprietorship or partnership, the calculation gets a little more involved. In this case your profit-sharing contribution is based on your modified net profit and is limited to 20%. The IRS provides a step-by-step formula for determining your modified net profit in IRS Publication 560.

Other Benefits of a Solo 401(k)

There are a number of other benefits that come with the solo 401(k).

Loans

As with other qualified plans, you may be able to borrow from a solo 401(k) up to (1) the greater of $10,000 or 50% of the balance or (2) $50,000, whichever is less. Check the plan document to determine if any other limitations apply. 

5500 Filing May Not Be Required

Because the plan covers only the business owner, you may not be required to file a Form 5500 series return if your balance is below $250,000.

No Nondiscrimination Testing

Generally, certain nondiscrimination testing must be performed for 401(k) plans. These tests ensure that the business owners and higher-paid employees do not receive an inequitably high amount of contribution when compared with lower-paid employees.

Such tests can be very complex and may require the services of an experienced plan administrator, which can be costly. Because the solo 401(k) plan covers only the business owner, there is no one against whom you can discriminate, so these tests are not required.

Deducting Contributions

Similar to other employer plans, the solo 401(k) allows you to deduct plan contributions of up to 25% of eligible compensation. For plan purposes compensation is limited in 2024 to $345,000. Earnings over that amount are disregarded for plan purposes.

The Bottom Line

If you own more than one business, you should check with your tax professional to determine whether you are eligible to adopt the solo 401(k). Ownership in another business that covers employees other than the business owner could result in your being ineligible for this type of plan.