Solo 401k Eligibility
A solo 401k plan has become the retirement account of choice over SIMPLE IRAs and SEP IRAs for the self employed, whether employed as a sole proprietor, independent contractor, consultant, through an LLC, Partnership or Corporation entity type.
In order to take advantage of what a Solo 401k has to offer—for example, high contributions, solo 401k participant loan, option to invest in alternative investments such as real estate, precious metals (gold and silver), tax liens, trust deeds, private company shares, etc., you first need to determine if you qualify to open a solo 401k.
The good news is that to qualify only the two following eligibility requirements must be met:
1) Self-employment activity: part-time or full-time
2) Without any common-law, full time employees
What Constitutes Self-Employment Activity for Participating in a Solo 401k?
Whether the self employment activity is generated through an LLC, C-Corporation, S-Corporation, Limited Partnership or Sole Proprietorship, to qualify as self employment activity the business must pursue steps to be profitable–that is generate “earned income.”
Although income derived from a partnership or sole proprietorship can be earned income, pass-through income earned by a shareholder in an S corporation is not classified as earned income. Guaranteed payments made to a limited partner is treated as net earnings from self-employment if the payment is for services to the partnership.
You should not open a Solo 401k if you are not truly planning to pursue self employment income.
Generally, the term “earned income” is defined to mean the individual’s net earnings from self-employment activities in a trade or business. (IRC 402(a)). In addition, the earned income must arise from the individual’s personal services and the personal services must be a material income-producing factor. (IRC. 401(c)(2)(A)(I); Reg. §1.401-10(c)(1). Income from the disposition of certain types of property is also deemed earned income. The purpose of the earned income rules from self-employment is to provide a solo 401k plan for the self-employed so that they can save for retirement, and to exclude inactive owners whose income is derived only from investments as investment income is not considered “earned income.”
Example 1 of Self-Employment Income
John, a former Major League baseball player, enters into a services agreement with a baseball glove maker under which he grants the maker the right to use his name and signature. Also, John agrees to perform promotional services for the glove maker. The royalties he receives are “earned income” only to the extent that they represent compensation for his promotional services. The royalties derived from the use of his name and signature are not treated as earned income.
Example 2 of Self-Employment Income
Susan is a realtor and receives a 1099-MISC on an annual basis. She then files a Schedule C with her Form 1040 to report her earned income for the year.
Example 3 of Self-Employment Income
Fees received for babysitting, house cleaning and lawn cutting are all examples of taxable income, even if performed on a part-time basis for the year. Someone who repairs computers in his or her spare time is also considered to be self-employed.
Example 4 of Self-Employment Income
Linda owns multiple properties which she rents out. She actively manages them (e.g., screens potential tenants, collects rent checks, performs some of the routine property maintenance, and arranges for contractors to perform some or all of the property improvements or repairs. Lastly, Linda performs these activities continually and regularly with the intent to generate income or profit; therefore, her rental activity is a business.
What Amount of Earned Income is Required?
The IRS has not outlined the amount of revenue or profit the self-employed business must generate each year. Of course, in order to make contributions net self-employment income is required. You are not required to make annual solo 401k contributions.
You can participate in more than one qualified plan, but your contributions to all the plans cannot exceed the overall limits. For example, you can continue contributing to your day job’s 401k, establish a part-time business, subsequently open a Solo 401k for your part-time business and contribute to both 401k plans.
Full-Time Employees vs. Part-Time Employees
Even though a solo 401k is for owner-only businesses with no full-time W-2 employees, you can still qualify for a solo 401k if you have W-2 employees that fall under following:
Employees under age 21
Employees working part-time (working less than 1,000 hours per year)
Also, you can open a solo 401k plan even if your business employees the following:
Union employees
Nonresident alien employees
Business Owner’s Spouse Can Contribute to a Solo 401k
Since a Solo 401k is for business owners and their spouses, the business owner’s spouse is also eligible to participate in the same Solo 401k provided he or she is also self-employed in the business.
Author: Mark Nolan, Founder of My Solo 401K Financial
More details on 401K Eligibility: Click Here