Solo 401k plans are, by design, one participant plans, designed for company owners, partners and family businesses without common law employees. Except for Title I of ERISA Solo 401k plans must operate under the same rules and regulations as traditional 401k plans. Interest in Solo 401k Plans picked up after the passage of Economic Growth and Tax Relief Reconciliation Act of 2001 (also known as EGTRRA 2001). Prior to the passage of EGTRRA, previous law allowed the maximum deduction limit of 25 percent of compensation for combined employer profit sharing, match and employee salary deferral contributions to the plan.
The enactment of EGTRRA took Employee Salary Deferrals out of the deduction calculation.
With the passage of EGTRRA, employee deferrals were no longer part of the deduction limit calculation. Only the employer contributions were limited to up to a deduction limit of 25 percent of the employees compensation. Employee deferrals are no longer subject to the deduction limits of employer contributions. In 2009, that difference is an additional $16,500 in salary deferrals. Plus $5,500 more for those age 50 and older. This change created an opportunity for sole proprietors to maximize the contributions toward their retirement and reduce the taxes paid to the IRS.
The Solo 401k plan is a no brainer tax and retirement decision for business owners who do not have any employees, other than themselves and their spouse. However, if the business grows and the employer hires regular employees, the deduction and contribution advantages of the Solo 401k Plan can disappear.
If employees are hired and the new employees meet the eligibility requirements of the plan, they must be allowed to participate. With new employees, the Solo 401k plan, with its immediate eligibility and 100 percent vesting can become expensive for small employers. So do the new requirements for non discrimination testing of employee salary deferrals, employer match and employer profit sharing.
And if a plan is top heavy (where the key employees hold more than 60 percent of the plan assets) additional employer contributions of 3 percent of compensation will need to be paid to the accounts of the new employees.
The plan also comes under the Fiduciary requirements and the Reporting responsibilities of Title I of ERISA. And should the new employee decide not to contribute to the plan, the non discrimination rules prevent the employer from making any salary deferrals at all. On top of all that the cost of administering the additional plan requirements will often triple.
What to Do When You Know You will be Hiring New Employees.
You know in advance that you will be hiring new employees. If you will want to continue the contribution amounts and tax deductions you have been making, there is a temporary and a longer term solution.
The temporary solution is to change the eligibility period for participation from immediate to one year. The change in service eligibility will only allow you to continue making higher contributions and tax deductions until the end of the plan year in which the new employees works 1000 hours or 12 months. After that point in time, you will not be able to enjoy the tax and retirement advantages unless you employ the longer solution.
The longer solution is to amend you Solo 401k plan into a Safe Harbor Plan.
A Safe Harbor plan provides the following benefits to employers:
1. The non discrimination testing is automatically deemed to pass
2. Employers can contribute up to the maximum salary deferrals limit
3. If a plan is top heavy the safe harbor satisfies the top heavy contribution requirement
4. Safe Harbor Matching contributions are only provided to employees who make salary deferrals
The costs of the Safe Harbor plan include additional reporting plus a 100 % vested Safe Harbor matching contribution of up to 4% of salary deferrals made by all employees.
A quick Cost/Benefit analysis should convince any employer that the long term decision requires serious consideration.