Adopting a Solo 401(k) for 2020 in 2021

An overlooked SECURE Act change is that businesses can adopt new qualified plans and make deductible contributions after the close of the tax year. They must act before the due date for filing the employer’s return (including extensions). That means for solo 401(k) plans, individuals can adopt a plan and make contributions by May 17, 2021, for the 2020 tax year. They can extend this deadline further out if they obtain an extension.

SECURE Act Change

A business must adopt a qualified plan by the end of its tax year in order for a contribution to be deductible for that tax year. Qualified plans include pension plans, profit-sharing plans, stock bonus plans, annuity plans, and qualified cash or deferral plans (otherwise known as 401(k) plans).

Employers that lack a plan but want to make a contribution for the previous year can adopt a Simplified Employee Pension (SEP).  An employer can set one up as late as the due date for the employer’s return (including extensions) for the tax year. Although SEPs and defined contribution qualified plan contributions are generally subject to the same limits, SEPs do not have a cash or deferral option, which is a significant disadvantage.

Effective for plan years beginning after December 31, 2019, a business that adopts a qualified plan after the close of a tax year, but before the due date for filing its return for the tax year (including extensions) may treat the plan as having been adopted as of the last day of the tax year (Code Sec. 401(b)(2)).

COMMENT:  This change puts qualified plans (including 401(k) plans) on par with SEP plans for purposes post-year end adoption.

What are Solo 401(k)s?

A solo 401(k) plan is a one-participant traditional 401(k) plan covering a business owner with no employees. These plans have the same rules and requirements (for the most part) as any other 401(k) plan. They can include the owner’s spouse, or partners and their spouses.

A one-participant plan is a plan that, on the first day of the plan year:

  • covers only one individual (or the individual and the individual’s spouse) and the individual (or the individual and the individual’s spouse) owned 100 percent of the plan sponsor (whether or not incorporated), or
  • covers only one or more partners (or partners and their spouses) in the plan sponsor.

PLANNING NOTE: Due to the simplicity of a one-participant plans, a prototype plan (whether or not designed specifically to cover just the owner of the plan) will nearly always work as the plan document. Many financial firms offer solo 401(k)s.

Contribution Advantages of Solo 401(k)s

The business owner is both employee and employer in a 401(k) plan, and contributions can be made to the plan in both capacities. The owner can contribute both:

  • elective deferrals up to 100 percent of compensation (earned income in the case of a self-employed individual) up to the annual contribution limit ($19,500 for 2021, or $26,000 if age 50 or older); and
  • employer nonelective contributions up to 25 percent of compensation as defined by the plan (for self-employed individuals, the amount is determined by using an IRS worksheet and, in effect, limits the deduction to 20 percent of earned income).

Elective deferrals are treated as ordinary compensation for deduction purposes and so they expand the employer’s retirement contribution deduction limit (25 percent of compensation or 20 percent of earned income), while not using up the limit. That means that an individual who adds a solo 401(k) feature to a profit-sharing or money purchase plan can contribute significantly more.

EXAMPLE 1.  In 2021, Josie’s Handywoman Service, Inc., has only one employee, Josie, age 32, who has annual earnings of $100,000. If the business adopts a qualified profit-sharing plan, the maximum amount that can be contributed and deducted for Josie is $25,000 (25 percent × $100,000). If the plan also has a qualified cash or deferred feature (i.e., a 401(k) plan), Josie could elect to defer an additional $19,500 (for 2021) for a total contribution of $44,500.

EXAMPLE 2. Same facts as Example 1, except that Josie earns $50,000. If the business makes a contribution for Josie to a profit-sharing plan, the contribution would be limited to $12,500 (25 percent × $50,000). If the plan has a 401(k) feature, the business can contribute an additional $19,500 for a total of $32,000.

A factor that limits the usefulness of this double role for higher-income individuals is the statutory limit with respect to total contributions to a participant’s account. Under this limit, an employer can only deduct a set inflation-adjusted maximum amount (e.g., $58,000 for 2021) for contributions to each participant’s account (catch-up contributions fall outside of this limit).

EXAMPLE 3: Same facts as Example 1, except Josie earns $200,000 in 2021. Whether the business’ profit-sharing plan has a 401(k) feature or not, it would only be able to deduct a maximum of $58,000 due to the $58,000 inflation adjusted statutory limit on per-employee contribution deductions. But, even in this case, if Josie were eligible (i.e., by being age 50 or older), the 401(k) feature would allow an additional catch-up contribution of up to $6,500 that would fall outside of the limit.

CAUTION:  If the business owner also works for another firm and participates in its retirement plan, the contribution limits are applied on a per-taxpayer rather than per-plan basis. For example, if the owner can elect to defer $19,500 in the tax year, the owner can defer up to a total of $19,500 for both plans combined rather than $19,500 for each plan.

Conclusion       

Solo-401(k)s make a lot of sense in comparison to a SEP, especially when it comes to maximizing contributions. One of the few advantages of a SEP has been that it could be adopted and contributions could be made after the end of the tax year. That is no longer the case.

By James Solheim, J.D.

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CCHTaxGroup

All stories by: CCHTaxGroup