Tax Tip – Solo 401(k) Plans

Tax Tips provided by Don Fitch, CPA

A so-called solo 401(k) plan (also known as a solo 401k, solo-k, uni-k, or one participant k) is simply a 401(k) plan that has either a single participant, who is a self-employed individual, or that individual and his or her spouse. A solo 401(k) plan is subject to the same rules and requirements as any other 401(k) plan.

Observation:

The solo 401(k) plan is not a new or even a different type of 401(k) plan. However, interest in such plans increased as a result of a tax law change that became effective in 2002. The Economic Growth and Tax Relief Reconciliation Act of 2001 changed the way salary deferral contributions are treated when calculating the maximum deduction limits for contributions to a 401(k) plan. Under pre-Economic Growth and Tax Relief Reconciliation Act law, the employer profit-sharing and matching contributions were combined with the employee deferral when determining the maximum deduction limit of 25 percent of employees’ compensation. Since Economic Growth and Tax Relief Reconciliation Act, however, the employee deferrals are removed from the deduction limit calculation. This created an opportunity for some people to put away additional amounts toward their retirement. The marketing for solo 401(k)s is aimed at business owners who do not have any employees, other than themselves and perhaps their spouse.

As with any other 401(k) plan, the employee deferral for a 401(k) plan is limited to the lesser of earned income or $19,500 for 2021 and 2020; $19,000 for 2019; or $18,500 for 2018 (Notice 2017-64; Notice 2018-83; Notice 2019-59; Notice 2020-79). This is called the Code Section 402(g) limit. If the employee is age 50 or older, an extra $6,500 (for 2020 and 2021) or $6,000 (for 2018 and 2019) may be deferred (Notice 2017-64; Notice 2018-83; Notice 2019-59; Notice 2020-79).

This extra amount is called a catch-up contribution. These deferrals can be either pre-tax or, if the plan allows, after-tax Roth 401(k) contributions. There is one limit per person for all types of elective deferrals. Thus, for 2020, a participant cannot defer $19,500 in pre-tax deferrals and an additional $19,500 in Roth contributions. However, the $19,500 can be split in any ratio between the Roth and the pre-tax elective deferrals. Deferrals must also be tested as an annual addition for purposes of the Code Section 415 limits. If the test fails, then the excess amounts deferred must be corrected.

Caution: Many of the advantages stressed by marketers of solo 401(k) plans vanish if the employer expands the business and hires more employees. If employees are hired and they meet the eligibility requirements of the plan and the Code, they must be included.

One issue regarding salary deferrals is how such deferrals are made when an individual is self-employed or involved in a partnership. The individual doesn’t usually know for certain what their income will be until the end of the year, or later. The 401(k) regulations address this issue and provide that a partner’s or self-employed person’s income is deemed available to them on the last day of their tax year. And since an employee must have a deferral election in place before compensation is available, a self-employed person may not make a cash or deferred election with respect to compensation for a partnership or sole proprietorship tax year after the last day of that year.

If a partnership provides for cash advance payments paid to the partner during the tax year that is based on the value of the partner’s services before the date of payment (and which do not exceed a reasonable estimate of the partner’s earned income for the tax year), the individual can defer a portion of these advances even though their final compensation has not yet been determined.

Additional Tax Tip:

If a self-employed individual wants to maximize his or her contribution, that individual cannot do so until his or her final compensation has been determined; however, the deferral election still must be in place as of the last day of the tax year.

Additional Tax Tip:

Employer contributions are not required to be made until the due date of the employer’s tax return, plus extensions. So, in the case of a sole proprietor, this is when the Form 1040 is due – October 15, if an extension was filed.

Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.

DON FITCH, CPA
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Palm Desert, CA 92260

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This blog post is intended to serve solely as an aid in continuing tax education for Don Fitch Accountancy blog, podcast, and/or email members. Due to the constantly changing nature of the subject of the materials, this product is not appropriate to serve as the sole resource for any federal tax, accounting opinion, tax return position, and must be supplemented for such purposes with other current authoritative materials. The information in this blog post has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. In addition, Don Fitch Accountancy is not engaged in rendering legal or other professional services and will not be held liable for any actions or suits based on this blog post, podcast, and/or email, or comments made during the above presentation. If legal advice or other expert assistance is required, seek the services of a competent professional.

(Updated 03/02/2021 06:19)

Published by Don Fitch, CPA

Offers in Compromise, Wage Levy Releases, Installment Agreements, IRS Audits, and much more IRS assistance. Also, allow us to Help you complete your Tax Returns from 1913 to present (100+ Years) and for any of the 50 States.

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