IRS Audits Focus on Solo 401(k)s

May 28, 2021

What You Need to Know

  • A solo 401(k) plan covers only the business owner and their spouse.
  • The IRS wants to know if small entrepreneurs have exceeded the annual pretax contribution limits.
  • Small-business owners often put documentation on the back burner.

Sole proprietors who maintain solo 401(k)s are able to capitalize on a number of benefits — from increased contribution limits to relatively minimal compliance requirements. In fact, compliance requirements are so minimal that business owners often forget about them until there’s a problem. For those business clients, it’s time to take notice. The IRS has recently announced that solo 401(k)s will be the focus of increased audit efforts — meaning that if your business client contributes to a solo 401(k), it’s time to review their status to determine whether everything is in order.

Solo 401(k) Requirements

A solo 401(k) is a 401(k) plan that covers only the business owner (the plan can also cover a spouse). In most ways, the solo 401(k) operates in the same manner as a traditional 401(k) —contributions are made on a pretax basis and subject to ordinary income taxes when withdrawn in retirement.

One key advantage of a solo 401(k) plan is that the employer-participant isn’t required to perform nondiscrimination testing because there are no employees, non-highly compensated or otherwise. Filing requirements are also minimal — if the plan’s assets are at least $250,000 at year-end, the plan is required to file an annual report on Form 5500-EZ.

Solo 401(k)s also allow the owner to make larger contributions each year. In 2021, the owner-employee can contribute up to $19,500 ($26,000 if the participant is 50 or older) in pretax dollars per year as an employee. The business owner is also permitted to contribute up to $38,500 to the plan as employer (for a total employer-employee contribution limit of $58,000 in 2021, or $64,500 for those aged 50 and up). 

However, employer contributions are also generally limited to 25% of compensation, up to the overall maximum of $58,000 (or $64,500, considering catch-up contributions).

The Focus of IRS Audits

Sponsors of solo 401(k)s are not permitted to have any employees. Thus, business owners who recently hired employees will no longer qualify for the solo 401(k) structure — meaning that they’ll be subject to the traditional nondiscrimination requirements that apply generally to 401(k) plans unless they satisfy certain safe harbor criteria.