A 401(k) plan established for just the business owner, or the business owner and spouse, has become a popular retirement plan and for many has replaced the SEP (Simplified Employee Pension plan) as the retirement plan of choice. This form of a 401(k) plan is often referred to as a “Solo‐K”.
The Solo‐K is preferred over a SEP for several reasons. First, in some situations it provides a greater tax deduction than a SEP. The deduction to the Solo‐K is limited to 25% of earned income plus any 401(k) deferrals (see #1 below) whereas the deduction to the SEP is capped at 25% of earned income (see #2 below). Second, a Solo‐K can include a participant loan feature whereas the SEP cannot. Third, the annual benefit limit (referred to as the Section 415 limit) is expanded by any 401(k) catch‐up contributions. Fourth, the Solo‐K can allow for ROTH 401(k) contributions, regardless of one’s income level, whereas the SEP cannot. Fifth, the Solo‐K can exclude employees who work less than 1,000 hours per year whereas the SEP cannot.
Example: A corporate business owner, age 50, earning $138,000/year could contribute $34,500 to a SEP (25% of $138,000). That same business owner could contribute in 2014 $57,500 to a Solo‐K [($138,000 x 25%) + $17,500 401(k) deferral + $5,500 401(k) catch‐up contribution]. The employee deferrals of $23,000 ($17,500 + $5,500) made to the Solo‐K can be after‐tax, ROTH contributions, if so elected and permitted by the plan document, regardless of the owner’s income (see #3 below).
Despite their popularity, businesses that adopt a Solo‐K need to avoid 5 key mistakes.
1. Employees improperly excluded from the plan. The Solo‐K must allow any employees within the “controlled group” to participate once the employees have met the plan’s eligibility provisions.
a. Example: Dave owns ABC Company that has only two employees, Dave and his wife, Sue. However, Sue owns a consulting firm, XYZ Company that has 5 employees. If Dave establishes a 401(k) for ABC Company, the plan must also include the employees of XYZ Company since the two entities comprise a “controlled group” through family attribution. In other words, Dave can not establish a ‘Solo‐K” for just him and his wife; the plan must cover all employees within the “controlled group”.
2. Failing to file Form 5500. Solo‐Ks that cover only the owner and his or her spouse are not covered by Title 1 of ERISA and are not required to file Form 5500 so long as the plan’s assets are under $250,000. However, an annual Form 5500 must be filed for any plan year where the assets exceed $250,000 or the plan covers someone other than the owner and spouse.
a. Example. John and his wife Sarah own a real estate company and sponsor a Solo‐K. Since the Solo‐K has assets in it totaling only $100,000, John has not been filing Form 5500. However, during the summer of 2013 John decides to employ his son, John Jr., to help with some mailings. If the eligibility requirements found in John’s Solo‐K Plan Document allow for immediate entry into the plan, (as most do) John Jr. will become eligible for the Solo‐K upon his date of hire. If so, starting with the 2013 plan year, it must file Form 5500 regardless of the amount of assets in the plan since the Solo‐K covers someone other than an owner and the owner’s spouse.
i. Solution: The eligibility provisions in a Solo‐K Plan Document can delay an employee’s entry into the plan until the January 1 or July 1 following the later of 1 year of service (see #4 below) or the attainment of age 21. Having such an eligibility provision is recommended since it may keep some part‐time employees from entering the Solo‐K and delay the entry date of others.
Solo‐Ks can provide great tax breaks and well‐needed retirement savings; however, care must be taken so that the plan stays in compliance with the web of complex tax laws.
1 In 2014, Solo‐K employee + employer contributions cannot exceed the lesser of a) $52,000 plus eligible Catch‐up contributions, or b) 100% of earned income
2 In 2014, SEP contributions cannot exceed $52,000
3 When finally distributed from the Solo‐K plan, any ROTH contributions, plus the earnings on those contributions, will be distributed tax‐free.
4 A “year of service” can be defined as a 12 month period, from the employee’s date of hire, during which time the employee works at least 1,000 hours.