By Ian Berger, JD
We’ve been getting a number of questions lately about whether it’s too late to set up a new solo 401(k) plan for 2020.
The answer is “sort of.”
Business owners with no employees (other than a spouse) can contribute to a solo 401(k) plan. Solo plans are typically used by sole proprietors but are also available if your business is incorporated or structured as a partnership or LLC.
In many cases, solo 401(k)s allow for a higher level of savings than SEP or SIMPLE IRAs. That’s because the IRS considers a business owner with a solo plan to wear two hats –an employee and an employer. This allows the owner to make elective deferrals as an employee and deductible employer contributions as an employer.
There are separate dollar limits for each. Elective deferrals are limited to $19,500 for 2020 and 2021 ($26,000 if age 50 or older). The employer contribution limit normally amounts to 20% of adjusted net earnings. There’s also an overall annual limit on combined contributions, but that limit is generous: For 2020, it’s $57,000 ($63,500 for those over age 50 deferring the additional $6,500 catch-up), and for 2021, it’s $58,000 (or $64,500 with catch-up).
Importantly, the elective deferral limit is per person (not per plan). So, if you have a solo 401(k) for your side job and a traditional 401(k) in your regular job, the most you can defer between both plans is $19,500, or $26,000 with catch-up.
Solo 401(k)s are easy to administer and don’t require the services of a TPA. They are exempt from IRS testing rules, and you don’t have to file a Form 5500 annual report until assets exceed $250,000.
The SECURE Act, enacted in 2019, includes a provision giving businesses extra time to set up certain new tax-qualified retirement plans. It used to be that a new workplace plan had to be adopted by the last day of the employer’s tax year. Now, businesses have until the due date for the corporate tax return, including extensions, to put a new plan into place. Depending on the type of business, that can be as late as the following September 15 or October 15.
So, what’s the problem for solo plans? The problem is that the extended deadline only applies to a solo 401(k)’s employer contributions – not to its elective deferrals. The IRS has a rule in place that says that a self-employed individual must make a deferral election by the last day of the year. If a deferral election for 2020 had to be made by 12/31/20, then a 2020 solo 401(k) offering elective deferrals must have been set up by that date.
That means it’s too late to adopt a solo 401(k) for 2020 if you want to make elective deferrals. But it’s not too late if you limit your 2020 savings to employer contributions. However, since elective deferrals aren’t allowed, the maximum 2020 contribution for a new solo plan adopted in 2021 (even for owners over 50) is $57,000.