Facts
I am self-employed, and my business is doing well. As a result, I would like to setup a retirement plan so that I can not only set aside some income for retirement but also to help with my current income tax planning. I don’t have any employees.
Question
I have been told that all I need to set up an individual 401(k) plan is a plan document and a brokerage account, and then I am all set. No ongoing costs or maintenance. Is that true?
Answer
The technically correct answer is “yes,” but there is much more to it from a practical perspective. For starters, it is important to note that there is no such thing as a Solo (k) plan or Individual (k) plan. Names like these are just marketing terms used to describe a regular 401(k) plan that happens to only cover a single individual.
These plans are subject to all of the regular rules that apply to other types of retirement plans; it’s just that when the plan only covers the owner of the business, many of those rules are considered to be automatically satisfied. For example, an owner-only plan…
- Is deemed to automatically satisfy the nondiscrimination requirements;
- Is not required to provide many of the standard disclosures such as the summary plan description, QDIA notice or the participant fee disclosure notice; and
- Is not required to file Form 5500 for any year it has less than $250,000 in total assets on the first day.
But all that is just the tip of the iceberg. Many institutions that tout the “easy” solution simply give the business owner a blank, check-the-box-type plan document to fill out and maintain for themselves. Since most small business owners aren’t experts in preparing plan documents, this approach can lead to all sorts of compliance problems, including:
- Failure to timely update the document for law changes;
- Checking the box for immediate eligibility, not realizing that doing so means that summer interns or part-time employees are now eligible for plan benefits; or
- If there are multiple owners, accidentally requiring all of them to receive the same level of benefits rather than creating flexibility for each owner to contribute different amounts.
There are other pitfalls that can come from going with a solo (k) in a box. Questions that need to be considered but are often overlooked include:
- Minority owners. Is the company a corporation with more than one owner? If so, those who own 5% or less may be considered non-highly compensated and/or non-key employees, subjecting the plan to nondiscrimination testing.
- Outside ownership interests. Does the owner of the company or any of his/her relatives hold ownership interests in any other companies? If so, it might be necessary to consider those other companies for retirement plan purposes.
- Form of compensation. Is the business a subchapter S corporation? If so, only amounts the owner takes as W2 compensation can be considered when determining the maximum allowable contributions. Year-end distributions of profits are ignored. If the business is a partnership or sole proprietorship, there are complicated circular calculations required to determine how much compensation is counted.
As for using a standard brokerage account to hold and invest plan assets, that isn’t always as easy as it sounds either. Although it might sound like a distinction without a difference in an owner-only setting, there are different rules that apply to different types of contributions. For example…
- 401(k) deferrals generally cannot be withdrawn prior to age 59 ½, while other types of contributions can.
- Roth and pre-tax deferrals receive different tax treatment upon distribution from the plan.
If all plan assets are comingled in a single brokerage account without any sort of breakdown by contribution source, those important nuances are lost, which can result in serious plan compliance issues.
While it is possible to get by with just a plan document and a brokerage account, there are a lot of moving parts that make it difficult to keep the plan in compliance without professional assistance. In addition to individual tax ramifications, missing any of these points (no matter how well-intentioned) can result in losing the owner-only status of the plan which could trigger additional testing, government reporting, and fiduciary liability.
For more information on plan documents, nondiscrimination testing and the Form 5500, please visit our Knowledge Center here, here and here, respectively.
