Individual 401(k) Plans – Buyer Beware

May 16, 2023

At a glance 

  • The main takeaway: The benefits of individual 401(k) plans may be undeniable, however, they are not “set it and forget it” arrangements. In fact, they are highly regulated with many complex rules and regulations.
  • Impact on your business: If you’re considering an individual 401(k) plan, it’s crucial to discuss with your tax advisor the options because certain missteps can be very costly.
  • Next steps: Aprio’s advisors can help you understand the various rules and regulations for each type of retirement plan and select the one that best suits your needs.

Schedule a consultation with an Aprio Tax advisor Today.

The full story:

Individual 401(k) plans, also known as solo(k)s and uni-(k)s, have become popular retirement vehicles for owner-only businesses with 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 used 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 whole host of regulations.

A brief background on solo(k) plans

Solo(k) plans grew out of regulatory changes made by the Economic Growth and Tax Reconciliation Act (EGTRRA) of 2001. Specifically, EGTRRA reconstructed the rules on how certain limits were calculated and set in motion higher overall employee and employer contribution limits. These changes, combined with certain discrimination testing nuances, laid the groundwork for the individual 401(k) plan concept. It should be noted that solo(k)s are basically a marketing concept that has no specific mention in the Internal Revenue Code. They are 401(k) profit sharing plans, nothing more and nothing less. The uniqueness is created because they automatically pass the arduous discrimination testing that all plans are subject to because the plans only cover business owners who meet the definitions of highly compensated employee (HCE) and key employee. This allows owners and/or shareholders to contribute up to the statutory limits each year without regard to 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, and if properly monitored individual 401(k)s work great under the right circumstances.

Solo(k) contribution limits

The annual contribution limits are periodically indexed and there is significant interplay between these limits that can be quite confusing. Listed below are the limits for 2023:

  • Employee contributions, pre-tax and ROTH 401(k) – $22,500 with an additional catch-up contribution of $7,500 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 – $66,000 from employee and employer contributions, plus $7,500 if eligible. (IRC 415)
  • Maximum compensation limit – for benefit calculation purposes $330,000. (IRC 401(a))

Beware of potential traps

Individual 401(k) plans are fairly straightforward in simple business arrangements. However, they are “company” sponsored retirement plans that are guided by significant rules and regulations. Additionally, how many business owners have a “simple business arrangement?” It’s common for financial advisors or accountants to recommend individual 401(k) plans, yet they have limited knowledge of the intricacies associated with these arrangements. Often, 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 an owner’s business structure to not be classified as simple and where important plan requirements are often overlooked:

  • Failure to keep plan documents up to date. The IRS requires plan documents to be updated periodically, which also applies to individual 401(k) plans. Currently, most pre-approved plans needed to be restated by July 31, 2022.
  • Failure to file Form 5500-EZ when the value of the plan assets exceeds $250,000.
  • Lack of coordination between contributions made to other retirement plans and the individual 401(k) plan. Specifically, employee contributions 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) plan 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) plan not being an individual plan after all.
  • Plans being set-up at the individual owner and/or 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 individual 401(k) plans 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 easy to correct while others can be very costly. It is highly recommended that business owners work with an advisor who truly understands the various rules and regulations for these plans.

Schedule a complimentary consultation with an Aprio Tax advisor to learn more about individual 401(k) plans or any other type of retirement plan vehicle.

Related Resources/Assets/ articles/pages 

Department of Labor Issued Final Revisions to the Definition of a Plan Participant for Form 5500

6 Important Provisions of the SECURE 2.0 Act

Key Employee Retention – Incentive Plans to Keep Key Employees on Board

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About the Author

Mark Flanagan

Mark Flanagan has more than 30 years serving for profit and nonprofit organizations of all sizes and industry types. His specialties include retirement arrangement consulting, compensation and benefits tax compliance, and benefit plan audit technical support. His expertise and guidance allow employers and individuals to defer taxable income from the highest corporate and individual rates to lower rates sometime in the future.