A Solo 401(k) plan is not a new type of retirement plan. It is a traditional 401(k) plan covering only one employee. In general, in order to be eligible to establish a solo 401(K) plan, one must be self-employed or have a small business with no full-time employees (over 1000 hours during the year) other than a spouse or other owner(s).
As the name implies, the Solo 401(k) plan is an IRS approved qualified 401(k) plan designed for a self-employed individual or the sole owner-employee of a corporation. It works best when there are no other employees or a very small number of employee.
One of the primary reasons the solo 401(k) plan is so popular with the self-employed is because it includes all the attractive options of a conventional 401(k) qualified retirement plan, but without the costly administrative requirements. This is because the Employee Retirement Income Security Act of 1974 (ERISA) rules and regulations do not apply to a Solo 401(k) plan since there are no non-business owner(s) to protect. ERISA is a body of federal law that sets minimum standards for pension plans in private industry.
The growing interest in the Solo 401(K) plans is a result of the passage of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) 2001. EGTRRA added certain features to the Solo 401(k) plan which significantly increased it appeal, such as (i) changing how salary deferral contributions are treated when calculating the maximum deduction limits for contributions, (ii) creating a Roth option, and (iii) extending the loan feature.
There are five main reasons that make the Solo 401(k) Plan a far more attractive retirement option for a self-employed individual or small business owner than a SEP IRA.
- Reach your Maximum Contribution Amount Quicker: A Solo 401(k) Plan includes both an employee and profit sharing contribution option, whereas, a SEP IRA is purely a profit sharing plan.
Under the 2018 Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $18,500. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $55,000.
For plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $24,500. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $61,000.
Whereas, a SEP IRA would only allow for a profit sharing contribution. Hence, a participant in a SEP IRA would be limited to 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum of $55,000 for 2018. No employee deferral exists for a SEP IRA.
For example, Ben, who is 60 years old, owns 100% of an S Corporation with no full-time employees. Ben earned $100,000 in self-employment W-2 wages for 2018. If Ben had a Solo 401(k) Plan established for 2018, Ben would be able to defer approximately $49,500 for 2018 (a $24,500 employee deferral, which could be pre-tax, after-tax or Roth, and 25% of his compensation giving him $49,500 for the year). Whereas, if Ben established a SEP IRA, Ben would only be able to defer approximately $25,000 (25% if his compensation) for 2018.
- Catch-up Contributions: With a Solo 401(k) Plan you can make a contribution of up to $55,000 to the plan for 2018 ($61,000 if the participant is over the age of 50). However, with a SEP IRA, the maximum amount that can be deferred is $55,000 since a SEP IRA does not offer any catch-up contributions.
- Roth Feature: A Solo 401(k) plan can be made in pre-tax, after-tax or Roth format. Whereas, in the case of a SEP IRA, contributions can only be made in pre-tax format. SEP IRA contributions can then be converted to a Roth IRA, but the initial SEP IRA contribution must be in pre-tax. In addition, for 2018, a contribution of $18,500 ($24,500, if the plan participant is over the age of 50) can be made to a Solo 401(k) Roth account directly.
- Tax-Free Loan Option: With a Solo 401(k) Plan, assuming your plan documents allow for it, you can borrow up to $50,000 or 50% of your account value, whichever is less. The loan can be used for any purpose. With a SEP IRA, the IRA holder is not permitted to borrow even $1 dollar from the IRA without triggering a prohibited transaction.
- Use Non-recourse Leverage and Pay No Tax: With a Solo 401(k) Plan, you can make a real estate investment using a non-recourse loan without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (Internal Revenue Code Section 514). However, the non-recourse leverage exception found in Internal Revenue Code Section 514(c)(9) is only applicable to 401(k) qualified retirement plans and does not apply to IRAs. In other words, using a Self-Directed SEP IRA to make a real estate investment involving non-recourse financing would trigger the UBTI tax, which could be close to 40 percent.