The 401(k) plan has become very popular among small business owners as a result of changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). These changes have made the 401(k) plan, in comparison to most other retirement plans, more beneficial and flexible for the small business owner. For the purposes of this article, we will refer to this special 401(k) plan as the “small business owner 401(k)”, or SBO 401(k).
The SBO 401(k) plan is for businesses whose only eligible participants in the plan are its owners.
A 401(k) by Any Other Name
The name assigned to the SBO 401(k) varies among financial institutions. An independent 401(k) is one of the most generic. Other examples include the “Individual(k),” “Solo 401(k),” “Uni-K Plan,” “one-participant K” and “Self-Employed 401(k).” If you are not sure which name your financial service provider uses, ask about the “401(k) plan for the small business owner.” The IRS provides this handy primer on such plans.
Is Your Business Eligible?
A common misconception about the SBO 401(k) is that it can be adopted only by sole proprietors. In fact, the SBO 401(k) plan may be adopted by any small business, including corporations, limited liability companies (LLC), and partnerships, provided that the only eligible plan participants are the business owners (or their spouses who are also employed by the business).
Individuals who are employees of one company (in which they have no ownership) and participate in its 401(k) can also establish a SBO 401(k) for a small business they run on the side, funding it with earnings from that venture. However, their aggregate salary-deferral contributions to both plans cannot collectively exceed the IRS-established annual contribution maximums (see below). Also, if their own company is operated as a corporation, contributions to the plan can be based only on the W-2 wages they receive from it.
Simpler Documentation Requirements
For small business owners who meet certain requirements, most financial institutions that offer retirement plan products have developed truncated versions of the regular 401(k) plan for use by business owners who want to adopt the SBO 401(k). The result is less-complex documentation used to establish the plan. For instance, a 20-page document for the regular 401(k) plan may be reduced to a three-page document for the SBO 401 (k). Make sure that you receive the proper documentation from your financial services provider.
Choose Your Eligibility Requirements
The SBO 401(k) plan may be adopted only by businesses in which the only employees eligible to participate in the plan are the business owners. For eligibility purposes your spouse is considered an owner of your business, so if your spouse is employed by your business, you are still eligible to adopt the SBO 401(k).
If your business has nonowner employees who are eligible to participate in the plan, your business may not adopt the SBO 401(k) plan. Therefore, if you have nonowner employees, they must not meet the eligibility requirements you select for the plan, which must remain within the following limitations.
You may exclude employees who are under age 21.
You may exclude nonresident aliens who receive no U.S. income and/or those who receive benefits under a collective-bargaining agreement.
Years of Service
- For 401(k) Employee Elective-Deferral Contributions: You may require an employee to perform one year of service before becoming eligible to make elective deferral contributions.
- For Profit-Sharing Contributions: You may require an employee to perform up to two years of service in order to be eligible to receive profit-sharing contributions. However, most SBO 401(k) plans limit this requirement to one year.
- For Plan Purposes: An employee is considered to have performed one year of service if he or she works at least 1,000 hours during the year. While you may generally choose to require fewer than 1,000 hours under a regular qualified plan, most SBO 401(k) plans include a hard-coded limit of 1,000 hours.
The Wrong Requirements
Making the wrong eligibility requirements could result in you being excluded from the plan or nonowner employees being eligible to participate in the plan. For instance, if you elect to have an age requirement of 21 even though you are only 20, you would be excluding yourself from participating in the plan.
Or say you elect zero years of service as a requirement to participate in the plan, but you have five seasonal employees who work fewer than 1,000 hours each year and are over age 21. These employees would be eligible to participate in the plan, because they meet the age and service requirements. Consequently, their eligibility would disqualify your business from being suitable to adopt the SBO 401(k) plan. Instead, you could adopt the regular 401(k) plan.
Some SBO 401(k) products, by definition, require further exclusions. Before you decide to establish an SBO 401(k) plan, be sure to check with your financial services provider regarding its provisions.
SBO 401(k) Plan Components
There are two components to the SBO 401(k) plan: employee elective-deferral contributions and profit-sharing contributions.
- Elective-Deferral Contributions: You may require an employee to perform one year of service before becoming eligible to make elective-deferral contributions. You may make a salary-deferral contribution of up to 100% of your compensation/income but no more than the annual limit for the year, which is $19,000 or $26,000 for age 50 or over in 2019 (both figures are $500 higher than in 2018).
- Profit-Sharing Contributions: You may require an employee to perform up to two years of service in order to be eligible to receive profit-sharing contributions. However, most SBO 401(k) plans limit this requirement to one year. The business may contribute up to 25% of your compensation (20% in the case of a sole proprietor or a Schedule C taxpayer) but no more than $56,000 for 2019 (up from $55,000 in 2018).
- Contribution Limits: The combined salary-deferral and profit-sharing contributions must not exceed $56,000 for 2019 (up from $55,000 in 2018). However, if you reach age 50 before the end of the year, you may contribute an additional $6,000 for catch-up contributions in 2019 (the same amount was permitted for 2018).
SBO Contributions vs. Other Plans
In comparison to other popular retirement plans, the SBO 401(k) plan has high contribution limits (as outlined above), which is the key component that attracts owners of small businesses. Furthermore, for other retirement plans the contributions may be limited to only employer contributions or, where salary deferral is allowed, the limit is less than that for the SBO 401(k) plan.
The following is a summary of contribution comparisons for the popular employer plans used by small businesses.
|Account||Elective Deferral||Maximum Employer Contribution||Catch-Up Contribution|
|SBO 401(k)||$19,000 for 2019, up from $18,500 in 2018||25% of compensation or 20% in the case of a sole proprietor or a Schedule C taxpayer||$6,000|
|SEP IRA||Not Allowed||25% of compensation or 20% of modified net profit for unincorporated business owners||Not Allowed|
|Profit-Sharing or Money-Purchase Pension Plan||Not Allowed||25% of compensation or 20% of modified net profit for unincorporated business owners||Not Allowed|
|SIMPLE IRA||$13,000 for 2019, up from $12,500 in 2018||3% of compensation/income||$3,000|
Let’s use an example to illustrate. Suppose that Jill, a sole proprietor who is under age 50, has a net profit of $70,000. Jill wants to adopt a retirement plan for her business, and she would prefer to adopt the plan that allows the highest contribution limit. The following table outlines the approximate maximum Jill would be able to contribute with each plan for 2018 (note that the 2019 contribution limits are higher).
|Account||Elective Deferral||Maximum Employer Contribution||Total|
|SBO 401(k)||18,500 (2018 limit)||$13,010.93||$31,510.93|
|Profit-Sharing or Money Purchase Pension Plan||$0||$13,010.93||$13,010.93|
|SIMPLE IRA||$12,500 (2018 limit)||$1,939.35||$14,439.35|
As mentioned earlier, you may make employee elective-deferral contributions of up to 100% of your compensation but no more than the elective-deferral limit for the year ($18,500 for 2018). Profit-sharing contributions are limited to 25% of your compensation (or 20% of your modified net profit if your business is a sole proprietorship or partnership). The total SBO 401(k) contribution is the employee selective-deferral contribution plus the profit-sharing contribution of up to $56,000 for 2019.
If your business is a corporation, the profit-sharing contribution is based on W-2 wages you receive. For instance, if you receive $70,000 in W-2 wages, your profit-sharing contribution could be up to $17,500 ($70,000 x 25%). When added to your salary-deferral contribution of $18,500 (as of 2018), this would be $36,000.
If your business is a sole proprietorship (like Jill’s business) or partnership, then the calculation gets a little more involved. In this case, your profit-sharing contribution is based on your modified net profit and is limited to 20%. For instance, in the example with Jill above, her net profit was $70,000. After making the necessary adjustments, Jill determined that her modified net profit was $65,045.65. The maximum employer contribution would therefore be $13,010.93 ($65,045.65 x 20%). Jill’s maximum contribution is $31,510.93, which is the total sum of both her $18,500 maximum salary-deferral contribution and $13,010.93 maximum profit-sharing contribution. The IRS provides a step-by-step formula for determining your modified net profit in IRS Publication 560.
Other Benefits of the SBO 401(k)
There are a number of other benefits that come with the SBO 401(k).
As with other qualified plans, you can borrow from the SBO 401(k) up to either 50% of your plan balance or $50,000, whichever is less. Check the plan document to determine if any other limitations apply.
5500 Filing May Not Be Required
Because the plan covers only the business owner, you may not be required to file Form 5500 series return unless your balance exceeds $250,000.
No Discrimination Testing
Generally, certain nondiscrimination testing must be performed for 401(k) plans. These tests ensure that the business owners and higher paid employees do not receive an inequitably high amount of contribution when compared to lower paid employees. These tests can be very complex and may require the services of an experienced plan administrator, which can be costly. Because the SBO 401(k) plan covers only the business owner, there is no one against whom you can discriminate, so these tests are not required.
Similar to other employer plans, the SBO 401(k) allows you to deduct plan contributions of up to 25% of eligible compensation. For plan purposes, compensation is limited to $280,000 for 2019 (up from $275,000 in 2018). Earnings of more than that amount are disregarded for plan purposes.
When the SBO 401(k) Is Not Suitable
The SBO is not suitable under the following circumstances:
- You have employees other than business owners who are eligible to participate in the plan.
- Your compensation is sufficient to allow you to contribute the $56,000 limit as profit-sharing contributions.
- Your business is incorporated, and you earn sufficient W-2 wages to allow the maximum contribution of $56,000.
The benefit of an SBO 401(k) is being able to make the maximum contribution possible. As the dollar limit is $56,000 for 2019, adopting an SBO 401(k) is not necessary if you receive W-2 wages from your business that would allow the maximum contribution amount of $56,000 to be achieved with pure profit-sharing contributions. Of course, if you are at least age 50, adopting the SBO 401(k) would allow you to make the additional catch-up contribution of $6,000.
Deadline to Establish an SBO 401(k)
The SBO 401(k) plan must be established by the last day of the tax year for your business. If you operate your business on a calendar year, the deadline will be December 31. However, if your business is incorporated, you may want to establish the plan sooner in order to make salary-deferral contributions, as they must be based on current or future wages, not wages paid before the plan is established.
The Dec. 31 deadline may change before long, however. The Family Savings Act - H.R. 6757, which would allow employers to adopt a solo 401(k) plan up to the business tax filing date, passed the House in September 2018 and is awaiting a Senate vote.
Profit-sharing contributions must be made by your tax-filing deadline, including extensions. Amounts representing salary-deferral contribution must be contributed by the seventh business day of the month following the month to which the deferral applies if your business is incorporated.
For instance, amounts deferred from your salary in September must be deposited to your 401(k) account by the seventh business day of October. Because salary-deferral contributions cannot be based on compensation earned before you make an election, you must make your election before the first pay period by which you want to begin making salary-deferral contributions.
For unincorporated businesses, your selective deferral contributions may be deposited by your tax-filing deadline, including extensions. However, your salary-deferral election, including the amount you plan to defer, must be made by the last day of your tax year.
If you own more than one business, you must check with your tax professional to determine whether you are eligible to adopt the SBO 401(k). Ownership in another business that covers employees other than the business owner could result in your being ineligible for this type of plan.