Q: I have a small side business that is really starting to take off. Someone told me that I should think about setting up a solo 401(k) plan in my side business to help boost my retirement savings. I already have a 401(k) through my regular employer. Is it possible to do a solo 401(k) with my side business? Would it be beneficial?
A: If you and your spouse are the only full-time employees in your side business, a solo 401(k) could be a good idea. In most situations, solo 401k plans are easy and straight-forward. However, like all retirement plans, there are some rules you need to follow. If you break the rules, your 401(k) plan could be disqualified—a situation that could lead to unpleasant tax headaches. You probably want to work with an advisor to make sure you get it set up correctly.
The term “solo 401k” is another name for what the IRS refers to as “one-participant 401(k) plans.” These plans have the same rules and enjoy the same protections as any other 401(k) plan. Like their larger cousins, solo 401k plans are organized under the Employee Retirement Income Security Act of 1974 (ERISA) and enjoy all the legal protections ERISA affords. Elective deferral limits and catch-up provisions for participants are the same as in larger plans, as are annual overall contribution limits. Participants can even borrow money tax-free on the same terms and conditions as the larger plans.
To qualify for a solo 401k plan, a business can have no full-time employees except the owner and the owner’s spouse or partner, if the business is a partnership.
Because solo 401(k) plans have only one participant, they are much simpler to administer. For example, since there are no employees beyond the owner, solo 401k plans do not need to do the nondiscrimination tests that larger plans require. Solo 401(k) plans can be set up for sole proprietorships, S Corporations, C Corporations, partnerships and LLCs.
As the owner of your small business, you are both employer and employee when it comes to the 401(k) plan. If your company pays you a W-2 wage, the limits on your solo 401k plan contributions are easy to calculate. As an employee, you can defer up to 100 percent of your compensation or $20,500 in 2022, whichever is less,. If you are 50 years old or older, your elective contribution limit is $27,000.
As the employer, you can also make nonelective contributions up to 25 percent of your compensation provided that total contributions to your account do not exceed $61,000 in 2022. If you are 50 years old or older, your annual contribution limit would be $67,500.
If you are self-employed (meaning you are supported by the business, but are not paid W-2 earnings), things get a bit trickier. In that case, your contribution limits are based on your net earnings from self-employment after deducting one-half of your self-employment tax and the amount of contributions you have made to the plan on your behalf. I know it’s confusing. Even the IRS admits the reasoning is circular. Let’s just say you would do well to get an advisor to help you with the calculations.
Solo 401k plans can accept Roth contributions if they come as elective deferrals from you as employee. Employer nonelective contributions can only be made on a traditional (pre-tax) basis. Remember that you will not get a current-year tax deduction for your Roth deferrals and that tax-free withdrawals from the Roth are available only after the Roth 401k account has been established for five years. The five-year clock starts running at the time the first deposit is made into the Roth 401k account.
You can contribute to your solo 401(k) even if you are already covered by a 401(k) plan at your other job. However, your contribution limits are calculated at the individual level, not at the plan level. In other words, your limits are based on your total contributions across all plans in any given tax year. If you mistakenly contribute too much, work with your plan administrator to get the money out of your account by your tax filing deadline. If you wait until after the tax-filing deadline, your penalties multiply. Again, I recommend working with an experienced advisor to make sure you comply with the complex rules that govern retirement plans.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.