Buyer Beware: Individual 401(k) Plans

Individual 401(k) plans, aka solo(k)s, uni(k)s etc., have become very popular retirement vehicles for owner only businesses, with popular vendors and the media regularly touting their merits. These plans are typically stripped down versions of “full blown” 401(k) plans with a reduced administrative and reporting burden. When utilized in the correct situation, solo(k) plans are excellent tools for making tax deductible contributions and accumulating retirement assets. However, they are still formal retirement plans that must adhere to a number of regulations.

Background

Solo(k) plans grew out of certain regulatory changes made by the Economic Growth and Tax Reconciliation Act of 2001 “EGTRRA”. Specifically, EGTRRA remade the rules regarding how certain limits were calculated, and it also set in motion higher overall employee and employer contribution limits. These changes, combined with certain discrimination testing nuances, laid the ground work for the individual 401(k) plan concept.

It should be noted that solo(k)s are basically a marketing concept that are not specifically mentioned in the Internal Revenue Code. These are simply 401(k) profit sharing plans, nothing more and nothing less. However, they are unique because they automatically pass the arduous discrimination testing that all plans are subject to. This is because the plans only cover business owners who meet the definitions of highly compensated employee “HCE” and key employee. This allows owners/shareholders to contribute up to the statutory limits each year without regard for the discrimination testing rules, typically ADP/ACP and coverage tests.

Individual 401(k)s are extremely attractive, because unlike the other popular micro business retirement vehicle, the Simplified Employee Pension “SEP,” owners can make employee and employer contributions. A SEP only permits employer contributions. They work great under the right circumstances and if properly monitored.

Contribution Limits

The 2022 limits are detailed below. The annual contribution limits are periodically indexed.

• Employee contributions, pre-tax and ROTH 401(k), $20,500 with an additional catch-up contribution of $6,500 for individuals that reach age 50 anytime during the year – IRC 402(g).
• Maximum deductible employer contribution, 25% of w-2 eligible wages. For self- employed individuals, the maximum is 20% of net self-employment income less ½ self-employment tax – IRC 404.
• Maximum annual additions, $61,000 from employee and employer contributions plus $6,500 if eligible – IRC 415.
• Maximum compensation limit for benefit calculation purposes $305,000 – IRS 401(a).

There is significant interplay between these limits that can be quite confusing.

Potential Traps

Individual 401(k) plans are fairly straightforward in simple business arrangements. However, they are “company” sponsored retirement plans that are guided by many rules and regulations. Additionally, how many business owners have a “simple business arrangement?” Many individual 401(k) plans are recommended by financial advisors or accountants that have limited knowledge of the intricacies associated with these arrangements. Often times, the initial consulting on the plan’s appropriateness and ongoing maintenance is nothing more than directing a client to a vendor’s website. While there are times when this is sufficient, the times when it is not can be very costly!

The following is a list of common situations that can cause a business owner’s business arrangement to not be simple, as well as important plan requirements that are often over looked.

• Failure to keep plan document up to date. The IRS requires plan documents to be periodically updated. This requirement applies to individual 401(k) plans as well. Currently, most pre-approved plans need to be restated by July 31, 2022.
• Failure to file form 5500-EZ when the value of plan assets exceeds $250,000.
• Lack of coordination between contributions made to other retirement plans and the individual 401(k) plan. Specifically, employee withholdings cannot exceed the annual 402(g) limit across all plans in which the owner participates.
• Overall lack of understanding that even an individual 401(k) has rules that need to be followed.
• Failure to consider ownership in other entities of the owners and their spouses. The common ownership rules are extremely complex and can often result in an Individual 401(k) not being an individual plan after all.
• Plans being set-up at the individual owner/shareholder level and not at the entity level. This can create a myriad of problems when the entity itself has non-owner w-2 employees.

The Bottom Line

The benefits of the individual 401(k) plan are undeniable. However, they are not “set it and forget it” arrangements. They are highly regulated, with many complex rules and requirements. Certain missteps are fairly easy to correct, while others can be very costly. It is highly recommended that business owners work with an advisor who truly understands these plan’s rules.

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