Any business can establish a 401(k) plan. A business with no full-time employees (less than 1000 hours worked during the year or 500 hours in two consecutive years) other than the owner(s) or their spouse(s) can establish a Solo 401(k) plan which allows the business owner to contribute the lesser of:
- 100 percent of the employee’s compensation, or
- $58,000 for 2021 ($57,000 for 2020) or $64,500 if over the age of 50 ($63,500 for 2020).
Whereas, a business that has non-owner full-time employees would establish a 401(k) plan and offer plan benefits to the employees.
The Solo 401(k) plan contribution rules are the foundation of the Solo 401(k) plan. There are three types of contributions that can be made to a Solo 401(k) plan: (i) employee deferrals, (ii) employer profit sharing contributions, and (iii) after-tax contributions. Note – your plan adoption agreement must allow for after-tax and employer profit sharing contributions. For 2021, no more than $290,000 of an employee’s compensation ($285,000 in 2020 and $280,000 in 2019) can be taken into account when figuring contributions.
Employee Deferrals & After-Tax Contributions
In short, the IRC 402(g) rules allow employees to make tax-deductible or Roth plan employee deferral contributions up to $19,500 or $26,000 if at least age 50 for both 2020 and 2021. After-tax contributions are not subject to the employee deferral 402(g) limits and are not considered employer contributions. After-tax contributions are not tax deductible or Roth. So long as your plan documents permit, after-tax contributions can be made dollar-for-dollar up to the IRC 415 limit and can then be converted to Roth or rolled into a Roth IRA without a plan triggering event.
Employer Profit Sharing Contributions
The majority of Solo 401(k) plan documents allow for employer plan contributions, also known as profit sharing contributions. In essence, a business can make a tax-deductible additional contribution to the plan for the benefit of each eligible employee in an amount up to 25% of the participant’s W-2 compensation (20% in the case of a sole proprietor or single member LLC net Schedule C income).
Employer contributions are made by the business and are also 100%. In addition, employer profit sharing contributions are tax deductible to the business but can be converted to Roth by the plan participant, if permitted by the plan, and would be subject to tax. Employer profit sharing contributions can be made by the business up until the business filed its tax return, or in the case of a sole proprietor of single member LLC, when it filed its 1040 income tax return.
For example, if the sole owner of an LLC, who is under 50, earned $60,000 of net Schedule C income in 2021, the individual would be able to make employee deferral contributions of $19,500 plus the business can make a 20% employer profit sharing contribution equal to $12,000 (20% of $60,000) providing the individual with a total of $31,500 in plan contributions and tax deductions. Since, $31,500 is less than the IRC 415 limit of $58,000 for 2021, the entire amount of the employer profit sharing contribution would be permitted.
Employer Contribution – Tax Planning Among Owners
However, what about the situation where there are two or more owners or an owner and a spouse where one owner earns a higher salary or share of the earned income than the other. Well, some very interesting tax planning opportunities present themselves that are not widely unknown except to tax and pension plan experts.
Let’s take the example of Jen and Bill. Assume Jen earns $220,000 of W-2 income from an S Corp and Bill earns just $60,000 in 2021. Both Jen and Bill are under 50. Let’s assume both Jen and Bill make $19,500 employee deferral contributions and also want to make employer contributions as well. We know that Jen will be able to hit the maximum IRC 415 amount of $58,000 since 25% of $220,000 is $55,000. Hence, Jen will only be able to use $38,500 of the $55,000 available.
We also know that employer profit sharing contribution rules hold that the maximum employer profit sharing contribution for the business is 25% of all W-2 – $220,000 + $60,000 or $280,000. Thus, in the aggregate, the business is able to make employer profit sharing contributions in the amount of $70,000 ($280,000 x 25%). Jen was able to use $38,500 out of the $70,000, therefore, so long as your plan documents allow for it, Bill would be able to be allocated by the business $31,500 ($70,000-$38,500) in employer profit sharing contributions for a total of $51,000 including employee deferrals. Since that number is less than what he earned, or the 415 limit, the allocation will be respected.
This type of tax planning only works if one partner earns a considerable more than the other. Whereas, if Jen and Bill each earned $70,000, the maximum employer profit sharing contribution for both would be $17,500, so reallocating excess employer contributions would not be an option since neither partner would have exceeded their 415 limit.
Working with the right Solo 401(k) plan provider is important to ensure that you are maximizing all the available benefits allowable by the IRS and Department of Labor with respect to your Solo 401(k) plan. The employer profit sharing contribution can be quite tricky if you are not aware of these rules. Working with a qualified Solo 401(k) company, such as IRA Financial is imperative.
If you have any questions about how the Solo 401(k) contribution rules work, please contact us @ 800.472.0646 today.