Solo 401k Guide: What You Need to Know

This post encapsulates the history and qualification requirements, as well as the key benefits and features that have given rise to the tremendous interest in Solo 401k plans today.

Solo 401k: Also Known As Solo 401k plans are sometimes referred to as a Solo K, Individual 401k, One-participant K, One-participant 401k, or Uni-K.[1]

Solo 401k: Not a New Type of Retirement Plan

The Solo 401k is not a new type of retirement plan.  It is simply a 401k – with the same legal authority as 401k plans offered by Fortune 500 companies such as Google, Southwest, and Walmart.  Rather than a 401k plan covering thousands of participants a Solo 401k is a one-participant plan (e.g., the self-employed individual).

The legal basis for today’s 401k plans began with the Employee Retirement Income Security Act of 1974 (ERISA) which Congress enacted on Labor Day 1974.[2]  ERISA allowed defined contribution plans to delegate investment responsibility to participants (i.e., employees who participate in the plan)[3], which is the basis for today’s participant-directed 401k plans.

While participant-directed retirement plans have been around since 1974, it wasn’t until 2002 that Solo 401k plans started increasing in popularity following the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).  EGTRRA made a simple yet very impactful change to the contribution limits applicable to Solo 401k plans.  Prior to the enactment of EGTRRA, it made more sense for self-employed individuals to save for retirement through a SEP or SIMPLE IRA because the annual contributions limits were the same as a Solo 401k, but the SEP and SIMPLE IRA were easier to administer.  With the enactment of EGTRRA, elective deferrals are not taken into account for purposes of deduction limits. [4] In other words, the employee contributions to a 401k plan do not count toward the limit.  With the ability to contribute employee deferrals in addition to employer contributions, a self-employed person can contribute more money to a Solo 401k than to a SEP-IRA – for 2013 the  maximum annual-contribution limit including both employer and employee contributions  is $51,000 (or $56,500  if you are age 50 or older).   This ability along with other important benefits described below led to a surge in interest in Solo 401k plans.

Solo 401k Qualifications: Who can open a Solo 401k

·        Self-Employment: Only a self-employed individual is eligible to set up a Solo 401k (e.g., a person who earns income from a trade or business where his or her personal services are a material income-producing factor).[5]  An individual whose only source of employment is working as a W-2 employee for a Fortune 500 corporation is not eligible to open a Solo 401k.  Neither is an individual whose only source of income is as a silent partner in a partnership. 

·        All Business-Entity Types: A Solo 401k can be adopted by any self-employed business, including a sole proprietorship, limited liability company, partnership, C-Corporation, S-Corporation etc.

·        No employees: Other than the spouse(s) of the business owner(s), the business must not employ any other full-time employees (i.e., an employee who works 1,000 hours or more per year).[6]

 

Solo 401k Benefits & Features: Flexibility and Control

 

• Checkbook Control Solo 401k:  A checkbook feature can be added to a Solo 401k - hence why it’s often called Checkbook Control Solo 401k.  If you plan to invest in alternative investments such as real estate, precious metals, trust deeds, tax liens, etc., a checkbook feature is more cost effective and faster than going through a self-directed Solo 401k custodian (e.g, Entrust, Equity Trust, Pensco Trust, etc.) that will require the submission of investment instructions and charge transaction fees.  Instead, you simply write a check from the Solo 401k checking (or brokerage) account, and you safekeep the paperwork in connection with the alternative investment purchases. Note: For those looking to invest in both traditional investments (e.g., stocks, mutual funds, etc.) in addition to alternative investments (e.g., real estate, precious metals), you can open a Solo 401k with checkbook control at certain brokerage firms (e.g., see Fidelity Solo 401k with Checkbook Control).
• Alternative Investment Options (e.g., Real Estate, etc.): A Solo 401k is often referred to as self-directed 401k because the rules allow for investing in alternative investments such as precious metals (Solo 401k Gold), real estate, trust deeds, private company shares, currency, etc.  For a list of more investment types visit Solo 401k Investments.
• Solo 401k Loan (borrow from Solo 401k):  EGTRRA allows owner-only business owners to borrow from his or her Solo 401k. The Solo 401k loan feature applies to each business owner separately, thus allowing each to borrow the maximum limit: 50% of balance not to exceed $50,000.  To learn more about the specific Solo 401k Loan requirements visit Solo 401k Loan.
• Make Roth Contributions:  A Solo 401k plan may permit business owners to designate some or all of their Solo 401k plan elective deferrals as after-tax Roth contributions.  Please note that this is true 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.  To learn more please visit Solo 401k Roth Option.
• Simplified Administration Requirements: While Solo 401k falls under same legal authority as the traditional 401k plans offered by Google, Southwest and other companies, the administration requirements applicable to a Solo 401k are much easier to manage.  For example, a Solo 401k is exempt from nondiscrimination testing which applies to 401k plans that cover multiple participants. Moreover, any required annual reporting requirement can be satisfied by filing the simpler Form 5500-EZ (note: this form is not required if the value of the plan assets does not exceed $250,000).  Finally, unlike an IRA a Solo 401k does not require the use of a special custodian (and the related expense can be avoided).  Instead, Solo 401k plans can be structured as trustee-directed plans where the business owner may serve as trustee of his or her Solo 401k.
• No Minimum Contribution Amount: Before the passage of EGTRRA companies that participated in a retirement plan were often required to make a certain minimum annual contribution - especially for money purchase and defined benefit plans. This is not the case for Solo 401k plans, however as there is no minimum annual Solo 401k contributions. This is especially beneficial if the business does not have a very profitable year.
• Opportunity to Consolidate Retirement Accounts:  With the exception of Roth IRAs, virtually all retirement accounts can be transferred/rolled over to Solo 401k.  As a result, a Solo 401k plan can serve as a good vehicle to consolidate all your retirement accounts.  Moreover, consolidating other retirement plans to a Solo 401k plan may allow you to greatly reduce fees, manage funds more easily and can gain tax free access to the rolled over funds through a Solo 401k loan.  Visit Consolidating Retirement Accounts to view complete list of retirement accounts that can be transferred to a Solo 401k.

Solo 401k Prohibited Transactions:

While a self-directed Solo 401k allows more investment flexibility, with more freedom comes more responsibility.  As such, make sure you are well versed in the prohibited transaction rules. For instance, make sure you understand what “self-dealing” means (e.g., your Solo 401k cannot participate in a transaction that benefits you, certain family members or your business). For a list of prohibited transaction examples visit: Solo 401k Prohibited Transactions.



CITATIONS:

1. http://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans
2. http://www.legisworks.org/GPO/STATUTE-88-Pg829.pdf
3. See ERISA § 404(c)
4. See ERISA § 404(c)
5. See also http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Business-Activities
6. See http://www.law.cornell.edu/uscode/text/26/410
7. See IRC Sec. 4975(d)