Did you know that 1 in 4 Americans have no retirement? Don’t want to be one of them. You started a small business, now can afford to put money away for retirement, but you don’t know how. 401(k)s have replaced pensions but you aren’t sure if they’re the best retirement vehicle for your small business. You’ve probably heard of a 401(k), but may not have heard of it’s little brother, the Solo 401(k). These are perfect for solopreneurs, or companies that only employ the owners.
Retirement Plans for Small Businesses
There are multiple retirement plans you can choose from for your small business. The most popular are:
- SEP IRAs
- SIMPLE IRAs
- Solo 401(k)s
- Regular 401(k)s
- Defined Benefit Plans
We’ve already covered SEP and SIMPLE IRAs, so today we are going over the next one on our list, Solo 401(k)s.
What is a 401(k)?
First things first, what are 401(k)s? Congress accidentally created 401(k)s in 1978 to limit the use of executive cash deferral plans. In other words, to make sure companies gave some of their profit to employees and not just executives.
It had a slow start, but 40 years later it has replaced the employee pension, becoming the #1 retirement benefit offered by employers. In fact, it’s now become such a staple of employee benefits, that companies can’t attract talented employees if they don’t offer a 401(k) or similar benefit.
How do 401(k)s work?
Simply explained 401(k)s allows employees to avoid paying tax when they put away a part of their paycheck for retirement. For example: your job pays you $40,000, but you elect to put $5,000 into your 401(k). You only pay tax on $35,000 ($40,000 minus your $5,000 401(k) contribution).
In addition to what the employee puts away, employers give their employees free money from company profits. This free money is usually referred to as the “company match” or company “profit share.” The amount that the company gives its employees is based on how the plan was initially set up. It can be a specific dollar amount or it can also be a percentage (%) of your salary.
Each company you work for will have a different profit share. However, in general, the profit share is usually somewhere between 3%-6% of employees’ salary, up to a certain dollar limit. Using the example from above: your employer’s 401(k) plan offers a 3% match of your salary, that means they will give you additional $1,200 ($40,000 salary x 3%) of free money.
What is a solo 401(k)?
A Solo 401(k)s is a special 401(k) in which there is only 1 participant* in the plan. That’s almost always the owner (or husband & wife owners.)
*Note: per the IRS, a married couple counts as a single participant for solo 401(k) plans.
Components of a 401(k)?
All 401(k)s have four components:
- Flavor of 401(k) – Traditional or Roth
- Contribution Limits
- Employee contributions
- Non-Elective Employer Contributions (often referred to as the Profit-Share)
Flavor of a 401(k)s
The flavor of a 401(k) is the difference between Traditional or Roth 401(k)s. They are the same as Traditional or Roth IRAs. Simply, you decide when you want to pay the tax on the money that you’ve put away for retirement.
Traditional means you get a deduction when you put the money away for retirement and pay the tax later, when you pull the money out.
Roth means you pay the tax now when you put the money away for retirement, and you pay no tax on the principal or the growth, later when you pull it out.
In either case, you can’t touch the money again until you’re age 59 ½, unless you want to pay the big-bad IRA a penalty. If you want more on the details between the two, you can read my article on Traditional and Roth IRAs here.
Solo 401(k) Total Contribution Limits
Contribution limits are the same for all 401(k)s (Traditional, Roth, Solo, etc.)
For 2021, depending on your income you can contribute either $58,000 per year (*or $64,500 if you’re older than 50 – the extra $6,500 is called “catch-up” contribution).
For 2022, depending on your income you can contribute either $61,000 per year (or $67,500 if you’re older than 50).
| Year | Limit | Limit > 50 Years Old* |
|---|---|---|
| 2022 | $61,000 | $67,500 |
| 2023 | $66,000 | $73,500 |
| 2024 | $69,000 | $76,500 |
Solo 401(k) Employee Contributions
The employee contributions are what comes out of the employees’ paycheck. Every year the IRS sets what it is (indexed by inflation). In 2024 the maximum is $23,000 ($30,500 if over 50), for 2023 the maximum is $22,500 ($30,000 if over 50).
Solo 401(k) Employer Profit Share
Before we explain how the employer profit share works, we need to define what it is to be self-employed. The IRS has very specific definition for what constitutes being self-employed. Anyone that meets one of these conditions are self-employed:
- A sole proprietor (solopreneur) or independent contractor
- You’re a member of an LLC or partnership
- You’re in business for yourself
You’re probably asking yourself, what if I own 100% of my own S-Corporation? You’d think that you’re self-employed since you own it, right? Wrong.
The IRS considers you an employee of the S-Corporation and not self-employed. Why? Because if you’re self-employed all your net income is subject to self-employment tax (an extra 15.3% tax). If you work as an employee for a corporation (even if you own it 100%) you only pay the extra 15.3% tax on the salary (W-2) the corporation pays you.
Are there more differences between the two? Of course, but this is all you need to know to calculate the employer profit share.
Percentage of Profit Share
Employer Profit Share for employees of Corporations – are the lessor of 25% of your employee salary (W-2) or government set maximum.
Employer Profit Share for self-employed people – are the lessor of 20% of your net income that’s subject to self-employment tax or government set maximum.
The government set maximum is reached by adding both your employee and employer contributions together (IRS One Participant 401(k) Plans link.)
Deadlines for Contributions
You must fund your contributions before you file your tax return. So, if you’re self-employed, your tax return is due April 15th or (October 15th if you extend), so you need to fund your 401(k) before then.
If you own an S-Corporation, your contributions are due by March 15th or (September 15th if you extend).
Deadlines for Setting up a Solo 401(k)
Unlike SEP IRAs, which you can set up all the way until you file your extension, solo 401(k)s must be set up by December 31st, of the year in which you want the funding to count. Here’s a table:
| Plan | Deadline |
|---|---|
| SEP IRA | Tax Return Deadline |
| 401(k) | 12/31 for year of plan |
Form 5500 for your 401(k)
Unlike SEP and SIMPLE IRAs, 401(k)s have a special tax return that usually needs to be filed with the Department of Labor (not IRS) call Form 5500. However, you don’t always have to file this form.
If you have a Solo 401(k) and the value of the assets in the 401(k) are less than $250,000, you don’t have to file the 5500.
Conclusion
Most of the rules for solo 401(k)s and regular 401(k)s, such as deadlines & contribution limits, are the same. However, regular 401(k)s have a few additional things you will need to consider (don’t worry, we will be writing an article about that with examples, so check back soon for that.)
In the mean time, keep in mind that all businesses are structured differently and have different goals. If you are considering setting up a small business retirement plan, please check with your CPA first so they can help you figure out which plan is best for your small business.