401k for Business Owners: Plan Options and Key Rules

A 401(k) plan is a retirement savings vehicle allowing business owners and their employees to contribute funds on a tax-advantaged basis. For an owner, establishing a 401(k) offers a competitive benefit to attract employees and is also a tool for personal wealth accumulation. These plans enable owners to build a retirement fund using company resources, with contributions growing tax-deferred until withdrawal.

The structure of a 401(k) plan provides tax planning opportunities. Contributions made by the business are tax-deductible, reducing the company’s current taxable income. This dual benefit of saving for the future while managing current tax liabilities makes the 401(k) a useful financial instrument for a business owner.

Available 401(k) Plan Options

Solo 401(k)

A Solo 401(k), also known as an individual 401(k), is designed for self-employed individuals or business owners with no employees other than a spouse. This plan is ideal for sole proprietors, independent contractors, and single-member S-corporations. Its advantage lies in high contribution limits and administrative simplicity, as it is not subject to the non-discrimination testing required of plans that cover more employees.

The structure of a Solo 401(k) allows the owner to contribute as both an “employee” and an “employer,” permitting a larger total annual contribution than many other retirement plans. Many Solo 401(k) plan documents also include provisions for participant loans, allowing the owner to borrow against their account balance. These features make it a common choice for single-person operations.

Safe Harbor 401(k)

For small businesses with employees, a Safe Harbor 401(k) offers an approach to providing retirement benefits that automatically satisfies certain annual non-discrimination tests. In exchange for this administrative relief, the employer must make specific contributions to their employees’ accounts, which must be 100% vested immediately.

There are two main types of safe harbor contributions. The employer can make a non-elective contribution of at least 3% of compensation to all eligible employees, regardless of whether they contribute. Alternatively, the employer can opt for a matching contribution, such as a 100% match on the first 3% of employee contributions and a 50% match on the next 2%.

Traditional 401(k)

A Traditional 401(k) plan offers flexibility for a business owner but also comes with significant administrative responsibilities. This plan is suitable for businesses that want discretion over employer contributions. Unlike a Safe Harbor plan, the employer can decide each year whether to make matching or profit-sharing contributions and can subject them to a vesting schedule.

This flexibility requires annual non-discrimination testing to ensure the plan does not disproportionately benefit highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). If the plan fails these tests, the business must take corrective actions, such as refunding contributions to HCEs or making additional contributions to NHCEs.

Contribution Rules and Limits

Employee Contributions (Elective Deferrals)

A business owner can make contributions as an “employee” to their own 401(k) plan. These elective deferrals are made through deductions from their compensation. For 2025, the Internal Revenue Service (IRS) limit for these deferrals is $23,500, which is the maximum an individual can contribute from their salary or earned income.

Participants age 50 or over are permitted an additional “catch-up” contribution. For 2025, the standard catch-up amount is $7,500. New rules allow a higher catch-up contribution of $11,250 for participants ages 60, 61, 62, or 63, while the $7,500 limit applies to those in the 50-59 and 64-and-older age brackets.

Many 401(k) plans offer a Roth contribution feature, allowing the business owner to designate elective deferrals as Roth contributions. These are made on an after-tax basis, meaning they do not reduce current taxable income. However, qualified distributions in retirement are tax-free, providing a tool for tax diversification.

Employer Contributions (Profit Sharing/Matching)

A business owner can also make a contribution on behalf of the company as the “employer,” often as a profit-sharing contribution. The business can contribute a percentage of the owner’s compensation to the plan, and this contribution is tax-deductible for the business.

The maximum employer contribution depends on the business structure. For incorporated businesses, the employer can contribute up to 25% of the owner’s W-2 compensation. For unincorporated businesses like sole proprietorships, the calculation is based on net adjusted self-employment income, which works out to a contribution of 20% of net earnings.

Overall Contribution Limit

The IRS sets a limit on the total annual additions to a 401(k) account, which includes both employee elective deferrals and employer contributions. For 2025, this overall limit is $70,000. Catch-up contributions do not count against this overall limit, effectively increasing the total amount for those eligible.

For example, a 55-year-old S-Corp owner with $200,000 in W-2 wages can make a maximum employee deferral of $31,000 ($23,500 + $7,500 catch-up). The business could contribute up to 25% of compensation ($50,000). However, the employee deferral (excluding catch-up) plus the employer contribution cannot exceed $70,000. This limits the employer contribution to $46,500 ($70,000 – $23,500), for a total contribution of $77,500.

Key Administrative and Fiduciary Responsibilities

Fiduciary Duty

When a business owner establishes a 401(k) plan, they become a plan fiduciary. This legal status requires them to act solely in the interest of plan participants and their beneficiaries, as mandated by the Employee Retirement Income Security Act of 1974 (ERISA). This duty involves managing plan assets prudently, diversifying investments, and ensuring plan expenses are reasonable.

A fiduciary must make decisions with loyalty and prudence. The owner must select and monitor investment options, oversee service providers, and ensure the plan operates according to its documents. Breaching these duties can result in personal liability for restoring any losses to the plan.

Non-Discrimination Testing

Traditional 401(k) plans require annual non-discrimination testing. These tests verify that the plan does not unfairly favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). The two main tests are the Actual Deferral Percentage (ADP) test for employee deferrals and the Actual Contribution Percentage (ACP) test for employer matching and employee after-tax contributions.

The ADP test compares the average deferral rate of HCEs to that of NHCEs, and the ACP test compares contribution rates. A plan must pass these tests each year to maintain its qualified status. As noted earlier, Solo 401(k) and Safe Harbor 401(k) plans are exempt from this testing, offering administrative relief.

Annual Reporting

Most 401(k) plans must file an annual report, Form 5500, with the Department of Labor (DOL) and the IRS. This form provides regulators with information about the plan’s finances, operations, and compliance. The specific version of the form depends on the plan’s size and type.

Small plans with fewer than 100 participants can file a simplified version, Form 5500-SF. An exception exists for one-participant plans like a Solo 401(k), which only need to file Form 5500-EZ once total plan assets exceed $250,000. The filing deadline is the last day of the seventh month after the plan year ends.

Establishing a New 401(k) Plan

Information Gathering and Preparation

Establishing a new 401(k) plan begins with selecting a plan provider, such as a financial institution or third-party administrator, to act as the plan custodian and recordkeeper. The owner must also choose the appropriate plan type based on the company’s structure and goals.

The owner must then decide on specific features, such as adding a Roth contribution option or permitting participant loans. These decisions are formalized in the plan adoption agreement, a legal document that outlines all the rules and features of the plan.

Procedural Actions for Plan Setup

The owner must sign the plan documents before the legal deadline. For a new plan to be effective for a given tax year, it must be established by December 31 for calendar-year businesses. An exception allows sole proprietors and single-member LLCs to establish a Solo 401(k) for the previous tax year up until their business’s tax filing deadline, without extensions, allowing prior-year contributions. For other business structures, the December 31 deadline applies for employee contributions.

Once the plan is legally established, a separate trust account must be opened to hold its assets, and initial contributions can be deposited. If the plan covers employees, the final step is to distribute required notices, like a Summary Plan Description, and provide enrollment materials to all eligible employees.