If you qualified as a self-employed entrepreneur and your business has no full-time employees, the Solo 401(k) is a fantastic self-directed retirement plan option.
A Solo 401(k) isn’t really a distinct type of retirement plan. It’s a specific implementation of a qualified employer 401(k) in an owner-only business environment.
This plan structure has the savings capacity of a true 401(k) plan, while providing you checkbook control over your assets. Plus, you can use a Solo 401(k) to invest in anything IRS rules allow.
Not only that, but a Solo 401(k) has a retirement plan structure that’s easy to manage. with limited reporting requirements in comparison to larger employer plans.
As the plan trustee, you’re only managing your own retirement savings, and not taking responsibility for the savings of others. This simplicity is what makes the Solo 401(k) format such a great self-directed investing platform.
Solo 401(k) Qualifications
To qualify for a Solo 401(k), you must have a for-profit business activity that serves as the business sponsoring the plan.
This can be a sole, proprietorship, LLC, or corporation. The entity format doesn’t matter, but the generation of earned income is required.
Second, your business may not have any non-owner employees working more than 1,000 hours per year (which is about 20 hours per week for the full year).
Can I Keep my Solo 401(k) if I Hire an Employee?
If the business sponsoring your Solo 401(k) hires any full-time employees, or if any other business you control has full time employees, then those employees are entitled by law to benefits coverage under the 401(k) plan.
Once a 401(k) has non-owner employees, it’s no longer the simplified Solo 401(k) version of the plan.
So what does that mean for your plan?
There’s no need to panic: Your plan can exclude a qualifying employee for up to one year of service, so you have time to create a proper transition strategy.
There are two directions you can take your plan:
- Upgrade to a full 401(k) plan and provide benefits to the employee(s), or
- Terminate the plan and rollover your savings to an IRA.
Let’s look at the pros and cons of each option below:
1. Upgrading your 401(k)
If you want to continue to make significant contributions to your retirement savings each year, then maintaining a 401(k) plan is the way to accomplish that.
However, there are tradeoffs:
- When you upgrade your Solo 401(k) to a full 401(k), the plan must file the long form 5500 return regardless of plan value.
- You must also perform annual non-discrimination testing on the plan to ensure that contributions are reasonably proportional for rank and file employees and highly compensated employees.
- There’ll generally be a requirement to have a 3rd party administrator involved in holding and reporting on plan investments.
- There may also be restrictions on the percentage of the plan that can be invested in “non-traditional” assets such as real estate.
- If the plan will continue to allow for non-traditional investments, then that capacity must be made available to all participating employees.
- As the plan trustee, you’ll need to obtain a surety bond, and will have some liability exposure with respect to any of the plan investments made both by you and by employees.
Continuing with a self-directed strategy in a full 401(k) plan format can be a daunting path. This is why it may be easier for you to simply rollover your plan into an IRA and start fresh with a new retirement plan structure/
Rollover to an IRA
If your Solo 401(k) holds non-traditional assets such as real estate, it may be simpler to terminate your plan and rollover your assets to a self-directed IRA.
This option allows you to maintain your current investments in a simplified structure.
As an individual plan, the IRA is not necessarily linked to the business. Plus, you can operate independently with your investments.
The type of IRA you choose to move to may vary depending on your situation and goals. You could simply rollover to a traditional IRA. This type of IRA does not allow for much in the way of future contributions, but would serve as a good repository for existing holdings.
And after a 1 year pause, your business could open a new 401(k) that’s a conventional plan focused on mainstream financial investments.
This could be a low-cost, easy-to-administer option that would provide the capacity for higher contributions without the complexities associated with holding non-traditional assets.
On the other hand, your business could sponsor a SEP or SIMPLE IRA. These IRA formats allow for higher contributions sourced from the employer. But they would also need to be offered to all employees.
The underlying accounts are individual in nature. So you could have a self-directed SEP capable of investing in real estate, while your employees could choose to hold their account in a mainstream brokerage, or choose to self-direct their accounts.
In the latter example, your employees’ self-direction would be their own operation. and you wouldn’t have the same kind of responsibility and exposure as an employer in a 401(k) format.
If you’re utilizing the Roth features of your 401(k), any assets held in that portion of the plan would need to be rolled over to a Roth IRA.
How to Plan Ahead
If you’re considering implementing a Solo 401(k) in your business, be sure to think about what your future plans for your business, and the potential for employees may be.
If hiring employees is a strategy that’s on the horizon, it may make more sense to go with an IRA based plan to start with.
If you have a business with a Solo 401(k) and are considering bringing on employees, reach out to your CPA and plan advisor to understand your options and the relevant timelines in advance. Planning for a transition can make that process a whole lot easier.