A Solo 401k account is a retirement savings option designed specifically for self-employed individuals and small business owners with no full-time employees (other than the owner and their spouse). These plans offer higher contribution limits than traditional IRAs and a broader range of investment options. For those who are both business owner and employee, a Solo 401k plan allows the flexibility to contribute as both, maximizing retirement savings potential.
But what happens if your business expands and you decide to hire employees? This is where understanding the eligibility requirements for Solo 401k accounts becomes critical. Hiring employees—especially full-time ones—can significantly impact your ability to maintain a Solo 401k account, potentially forcing a transition to another type of retirement plan. Knowing the rules can help business owners plan ahead and make informed decisions.
Eligibility Requirements for a Solo 401k Account
A Solo 401k account, also known as a One-Participant 401k, is essentially a traditional 401k plan but designed for businesses without employees. The primary eligibility requirement for this plan is that the business must have no full-time employees aside from the owner and their spouse.
Full-time employees are generally considered individuals working more than 1,000 hours per year. This restriction allows business owners to avoid the more complex compliance and administrative requirements typically associated with traditional 401k plans.
One notable exception to this rule is the use of independent contractors. Solo 401k plans allow business owners to hire independent contractors without impacting the plan’s eligibility. Independent contractors are not considered employees in this context because they don’t receive W-2 wages and manage their own taxes.
In short, if your business employs only you (and potentially your spouse) or independent contractors, you remain eligible for a Solo 401k. This also works in reverse. If you are an employee of a company, you cannot open a Solo 401k account, but if you are an independent contractor, you can qualify.
What Happens When You Hire Part-Time or Full-Time Employees?
Full-Time Employees
When you hire full-time employees (working more than 1,000 hours per year), your business no longer qualifies for a Solo 401k. The IRS views these additional employees as requiring full retirement plan coverage, which triggers the need for transitioning to a more traditional 401k plan. This is because 401k plans—unlike Solo 401ks—are subject to nondiscrimination testing and various compliance measures designed to ensure that benefits are extended to all eligible employees, not just owners.
Part-Time Employees Under the SECURE Act
The SECURE Act, passed in 2019, introduced new rules that affect how part-time employees are treated in relation to retirement plans. Specifically, part-time employees who work more than 500 hours per year for three consecutive years may also need to be offered retirement plan benefits.
If you hire part-time employees who meet this criterion, you may eventually lose eligibility for your Solo 401k account and need to adopt a different type of retirement plan that complies with these newer regulations.
Scenarios with Multiple Employees
If your business starts to grow and you hire multiple employees, the Solo 401k will need to transition to a traditional 401k plan that accommodates your workforce. This transition typically happens when either full-time employees are hired, or part-time employees work enough hours to trigger the participation rules under the SECURE Act. You will need to find a retirement plan provider capable of managing a more complex plan, ensure compliance with IRS nondiscrimination rules, and administer the plan for all eligible employees.
Hiring employees doesn’t necessarily mean the end of your retirement plan benefits—it just means you’ll need to adjust the type of plan to meet both your needs and those of your new employees.
Transitioning from a Solo 401k to a Traditional 401k
When to Transition
When you hire full-time employees or part-time workers who qualify under the SECURE Act, it becomes necessary to transition from a Solo 401k account to a traditional 401k plan. This shift ensures compliance with IRS and Department of Labor rules, especially regarding nondiscrimination testing and benefits for all eligible employees.
Steps for Transition
- Finding a New 401k Provider: Research and select a provider capable of managing a traditional 401k plan. Look for providers that offer comprehensive support, including plan administration, compliance testing, and employee education.
- Reporting Requirements to the IRS: Notify the IRS of your plan changes. You’ll need to file Form 5500, which reports information about your plan’s financial condition, investments, and operations. This ensures compliance with federal regulations. This is a far more extensive form than the 5500-EZ for a Solo 401k (one-participant) plan
- Managing the Rollover Process: Once you’ve selected a new provider, initiate the rollover process. You can transfer funds from your Solo 401k account into the new 401k account without tax penalties, provided you follow the proper procedures, such as ensuring a direct rollover.
Legal Compliance
Transitioning to a traditional 401k requires adhering to the Employee Retirement Income Security Act (ERISA) guidelines. ERISA mandates strict reporting, disclosure, and fiduciary responsibilities. Failing to comply can result in penalties or disqualification of the plan.
Alternatives to Solo 401k Accounts for Businesses with Employees
Small Business Retirement Plans
If you hire employees, there are several alternatives to a Solo 401k that cater to businesses with staff.
- SEP IRA (Simplified Employee Pension): A SEP IRA allows employers to make contributions to individual retirement accounts set up for their employees. It’s simple to administer, and employers can contribute up to 25% of an employee’s compensation. However, only employers can contribute to this type of plan, making it less flexible for employees who wish to make their own contributions.
- SIMPLE IRA (Savings Incentive Match Plan for Employees): A SIMPLE IRA is easier to set up than a traditional 401k and involves less administrative work. It allows both employer and employee contributions. Employers are required to either match employee contributions up to 3% of their salary or make a 2% contribution regardless of employee participation.
- Traditional 401k: The most common option for businesses with employees, a traditional 401k plan offers high contribution limits and the potential for employer matching. However, these plans require annual nondiscrimination testing to ensure that highly compensated employees don’t benefit disproportionately compared to lower-paid workers.
What Happens to the Solo 401k Contributions Already Made?
Rollover Options
If you need to transition to a traditional 401k, the funds already contributed to your Solo 401k account can generally be rolled over into the new plan without triggering taxes or penalties. You’ll need to ensure that the transfer is conducted as a direct rollover to maintain tax-deferred status on your savings.
Impact on Contribution Limits
Once you transition to a traditional 401k, contribution limits may change. You’ll need to consider the combined limits for employee and employer contributions. Additionally, employee contribution matching and profit-sharing will be factored into the plan, and nondiscrimination testing will determine if the contribution structure is fair across the board.
Employee Exclusions and Safe Harbor Provisions
Excluded Employees
Even if you hire part-time employees, not all may be eligible for plan participation. Employees who work fewer than 1,000 hours per year may be excluded from 401k plan participation, depending on the structure of the plan. This allows employers to minimize administrative responsibilities while still offering retirement benefits to full-time staff.
Safe Harbor Rules
If you want to avoid the complexities of nondiscrimination testing in a traditional 401k, adopting safe harbor provisions is an option. A safe harbor 401k plan automatically satisfies nondiscrimination requirements if the employer agrees to make certain contributions, such as matching employee contributions or providing a 3% non-elective contribution. This makes plan management easier while ensuring that all employees receive fair benefits. There is no Safe Harbor provision or testing in a Solo 401k (since there are no employees in the plan other than an “owner-employee”).
Tax and Administrative Implications
IRS Reporting
When you transition from a Solo 401k to a traditional 401k due to hiring employees, IRS reporting requirements increase. With a Solo 401k, reporting is fairly simple: if your plan holds more than $250,000 in assets, you must file IRS Form 5500-EZ annually.
When transitioning to a traditional 401k, however, you will need to file IRS Form 5500 instead, which involves more detailed reporting on the plan’s financial status, investments, and participant information. Additionally, you’ll need to provide regular employee benefit statements and comply with Department of Labor (DOL) requirements.
Tax Benefits
Although transitioning to a traditional 401k plan may seem complex, it still offers tax benefits for business owners and employees. Employer contributions remain tax-deductible, allowing businesses to reduce their taxable income.
Additionally, offering a 401k plan can make your business more competitive in attracting and retaining employees, while the matching contributions you make to employee retirement accounts are tax-deductible. Employees benefit from tax-deferred growth on their contributions, just as with Solo 401k plans, with the added advantage of potential matching contributions from the employer.
Costs of Administration
Managing a traditional 401k involves increased administrative responsibilities and costs compared to a Solo 401k account. Business owners must hire a third-party administrator to handle the plan’s paperwork, compliance testing, and employee communication, which can add significant expenses.
Additionally, there are often higher fees associated with managing the plan, such as record-keeping fees, advisor fees, and investment management fees. These costs can add up, but they are often necessary to ensure compliance with IRS and ERISA regulations.
Final Thoughts
If you’re considering hiring employees and want to explore how that impacts your Solo 401k, we encourage you to seek professional advice. A financial advisor can help you assess your business needs, select the right retirement plan, and make a smooth transition from Solo 401k to a broader employee-inclusive plan.
Frequently Asked Questions
What if I hire a part-time employee for less than 500 hours/year?
If your part-time employee works fewer than 500 hours annually, they are not considered full-time under IRS rules, and their employment will not impact your Solo 401k eligibility. However, be aware that under the SECURE Act, employees working more than 500 hours for three consecutive years may affect your Solo 401k account.
Can I still contribute to my Solo 401k account after hiring an employee?
Once you hire full-time employees, you cannot continue contributing to your Solo 401k. You will need to transition to a traditional 401k or another retirement plan that includes employee participation.
Do I have to terminate my Solo 401k immediately after hiring an employee?
You don’t have to terminate the Solo 401k account immediately, but you must stop making contributions once you hire a full-time employee. You may have a limited window to transition to another plan, so consult with a financial advisor for guidance.
