Solo 401(k)

A solo 401(k) is a 401(k) plan whose only participants are a business owner and, if the owner chooses, the owner's spouse. The IRS name is "one-participant 401(k) plan," and the agency also lists Solo 401(k), Solo-k, Uni-k, and One-participant k as names it sees in the market, so the informal label is accepted rather than wrong. The important part of the IRS's own description is the disclaimer attached to it. The plan "isn't a new type of 401(k) plan," and its rules and requirements are identical to any other 401(k). Contribution limits, Roth treatment, distribution rules, loan rules, and required minimum distributions all read exactly as they do in a thousand-employee plan. Everything genuinely specific to a solo 401(k) follows from one fact, that there are no common-law employees in it.

Two hats, and why 25% behaves like 20%. The owner is both the employee making salary deferrals and the employer making a nonelective profit-sharing contribution. Deferrals are capped at $24,500, and that cap belongs to the person rather than the plan, so an owner who also defers in a day job's 401(k) has one shared limit across both. The employer piece is limited to 25% of compensation. For an incorporated owner taking a W-2 salary, that is a clean 25% of the salary. For a sole proprietor or partner the base is "earned income," which Publication 560 defines as net profit reduced by both half of self-employment tax and the contribution itself. Because the contribution appears in its own base, a 25% plan rate resolves to a 20% rate applied to net earnings, and the publication's rate table prints that conversion directly. Combined employee and employer contributions are capped at $72,000 with catch-up contributions sitting on top of it, and compensation counted for the calculation stops at $360,000.

What the absence of employees buys. The IRS states that an owner with no common-law employees does not need to perform nondiscrimination testing, "since there are no employees who could have received disparate benefits." There is no actual deferral percentage test to fail, no top-heavy minimum to fund for anyone else, and no highly compensated employee determination that matters. That is the whole advantage, and the IRS is equally direct that "the no-testing advantage vanishes if the employer hires employees." A new hire who meets the plan's eligibility conditions must be included, and from that point the plan is an ordinary small-business 401(k) that either passes testing each year or adopts a safe harbor design to avoid it. Business owners who plan to hire should read the eligibility terms in the plan document before signing it, because those terms decide how long the exemption lasts.

A spouse counts as the owner, not as an employee. Because a spouse employed by the business can be covered without breaking the no-employees condition, a married couple running a business together can double the household's deferral capacity while the plan stays exempt from testing. The spouse has to be genuinely employed and paid.

Filing and paperwork. A one-participant plan is generally required to file Form 5500-EZ once it holds $250,000 or more in assets at the end of the year, and a plan with less than that is generally exempt from the annual filing requirement. This is a lighter obligation than a full 401(k) faces, but it is not nothing, and missing it is one of the more common failures the IRS sees in these plans.

The timing difference against a SEP IRA is the one that catches people. A qualified plan must be adopted by the last day of the tax year for contributions to be deducted for that year. There is a narrow exception for a sole proprietor who is the only participant and adopts a new 401(k) after year end, and even then deferrals have to be paid before the unextended filing deadline. A SEP IRA, by contrast, can be established as late as the return due date including extensions. Someone reaching March with no plan in place and a large prior-year profit usually has a SEP available and a solo 401(k) not.

The owner adopts a written 401(k) plan, opens the plan's account, elects a deferral amount by the end of the tax year, and then funds both pieces. Deferrals for an owner-employee must be elected by year end and can be deposited by the filing deadline including extensions; the employer contribution follows the same deposit deadline. Every other 401(k) rule then applies as written, including the Roth option if the plan document offers one.

A hypothetical example, using round figures for clarity. Dana is a sole proprietor with $120,000 of net profit on Schedule C and no employees. Her self-employment tax is figured on $110,820, which is 92.35% of the net profit, giving $16,955, so her deduction for half of it is $8,478. Subtracting that from net profit leaves net earnings of $111,522, and applying the 20% self-employed rate that corresponds to a 25% plan rate gives an employer profit-sharing contribution of $22,304. If Dana also defers $20,000 as an employee, total contributions are $42,304, comfortably inside the combined limit. The point of the arithmetic is that the employer piece is not 25% of $120,000.

Pros

• The two-hat structure usually allows a larger contribution at moderate income than an employer-only plan does, because the deferral is a flat dollar amount rather than a percentage.
• No nondiscrimination or top-heavy testing while the owner has no employees.
• Roth deferrals are available if the plan document provides for them, which no SEP-only arrangement offered before 2023.
• Plan loans are permitted if the document allows them, which IRA-based plans cannot offer at all.
• Contributions are discretionary year to year, so a lean year costs nothing.

Cons

• It generally has to be adopted by the last day of the tax year, so it is not a decision that can be made at filing time the way a SEP IRA can.
• Form 5500-EZ becomes an annual obligation once assets reach $250,000.
• Administration is heavier than a SEP or SIMPLE, with a plan document to keep current and restated when the law changes.
• The testing exemption ends with the first eligible hire, and the plan then costs meaningfully more to run.
• Deferrals are limited per person, not per plan, so a side business adds no extra deferral room for someone already deferring at a job.