Establishing a Solo 401(k) under the New Rules

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.  

A recent call with a financial advisor from Connecticut is representative of a common inquiry related to establishing a Solo 401(k) plan. The advisor asked: “My client is a sole proprietor and would like to set up a solo 401(k) plan for 2021. Are there any special considerations of which he needs to be aware?

Highlights of the Discussion

• Yes, there are special considerations with respect to establishing and contributing to a solo 401(k) plan.  For that reason, your client should work with his CPA, tax advisor and/or legal counsel to address all the issues.   

• In order to be able to make employee salary deferrals to the solo 401(k) for 2021, a sole proprietor would have to establish the solo 401(k) and execute a salary deferral election by December 31, 2021.  Here’s why. 

• Although the Setting Every Community Up for Retirement Enhancement (SECURE) Act, delayed the deadline for establishing a qualified retirement plan for a particular tax year until the business’s tax return due date, plus extensions, in practice, the delay only applies for facilitating the ability to make employer contributions (e.g., a profit-sharing contribution) for the prior year—not employee salary deferrals. Let’s take a look at an example. 

EXAMPLE

The 2021 maximum contribution for an unincorporated business owner to a solo 401(k) plan with enough earned income could be as high as $58,000 (or $64,500 if he or she turns age 50 or older before the end of the year). Anthony, a 54-year-old sole proprietor who earns $400,000, would like to set up a solo 401(k) plan for 2021. If Anthony establishes the solo 401(k) by December 31, 2021, and executes a salary deferral election by the same date, his maximum contribution for 2021 would be $64,500. 

If, under the new plan establishment rules, Anthony waits until sometime in 2022 before his extended tax filing deadline for 2021 (i.e., October 15, 2022) to establish a solo 401(k) for 2021, he could not make employee salary deferrals for 2021. Consequently, his maximum contribution in this scenario would be limited to $58,000 for 2021.        

• In all cases, a salary deferral election must be made prior to the receipt of compensation [Treasury Regulation (Treas. Reg.) 1.401(k)-1(a)(3)]. Pursuant to Treas. Reg. 1.401(k)-1(a)(6)(iii), for self-employed individuals (i.e., sole proprietors and partners), compensation is considered paid on the last day of the business owner’s taxable year (e.g., December 31, 2021 for 2021). Therefore, a self-employed person has until the end of his or her taxable year to execute a salary deferral election for “the plan.” Conservatively, that means the plan would have to be in place by December 31, 2021, as well to allow for the sole proprietor to make the salary deferral election.   

• The definition of compensation for contribution purposes for an unincorporated business owner is unique [IRC 401(c)(2)(A)(I)]. It takes into consideration earned income or net profits from the business but must be adjusted for self-employment taxes. Please refer to the worksheet for calculating contributions to a solo 401(k) plan for a self-employed individual in Publication 560, Retirement Plans for Small Businesses. 

Conclusion

For self-employed individuals and their tax advisors, there are several special considerations with respect to setting up and contributing to solo 401(k) plans, including, but not limited to, the deadline for establishing a 401(k) plan, the deadline for making a salary deferral election, and the owner’s compensation for contribution purposes.