Is a Solo 401K a Qualified Plan for Tax Purposes?

A Solo 401(k) is a retirement savings option for self-employed individuals and business owners with no employees other than a spouse. It offers high contribution limits, tax advantages, and investment flexibility, making it a strong choice for those looking to maximize retirement savings while minimizing taxable income.

While these plans provide benefits, they must meet IRS requirements to be considered “qualified” for tax purposes. Understanding qualification criteria, eligibility, and compliance is essential to avoid costly mistakes.

Criteria for Qualified Status

A Solo 401(k) must adhere to IRS structural and operational requirements to be recognized as a qualified plan. It must be established under a written document outlining contribution rules, distribution provisions, and loan availability. This document must comply with the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC) Section 401(a).

The plan must be maintained for the exclusive benefit of the account holder and any eligible participants. Contributions, earnings, and distributions must follow IRS rules to ensure tax-deferred growth or tax-free withdrawals if the plan includes a Roth component. While Solo 401(k)s are exempt from annual nondiscrimination testing required for larger employer-sponsored plans, they must still follow basic IRS guidelines.

Proper administration is required. If plan assets exceed $250,000, Form 5500-EZ must be filed annually. Failure to file can result in penalties of $250 per day, up to $150,000. The plan must also follow distribution rules, including required minimum distributions (RMDs) starting at age 73, as mandated by the SECURE 2.0 Act.

Eligibility to Establish

Only self-employed individuals or business owners with no full-time employees, other than a spouse, can open a Solo 401(k). This includes sole proprietors, independent contractors, single-member LLCs, and corporations where the owner is the only worker. A full-time employee is defined as someone working at least 1,000 hours in a 12-month period. Hiring additional staff beyond a spouse generally disqualifies the plan.

Eligibility also depends on earned income. Only self-employment income—such as sole proprietorship profits or wages from an S corporation owner—qualifies. Passive income, such as rental earnings or dividends, does not count. Contributions are based on a percentage of compensation, which must come from active business operations. A sole proprietor reports net earnings on Schedule C, while an S corporation owner uses W-2 wages to determine contributions.

Proper documentation of business activity is necessary. The IRS may require proof of self-employment, such as tax returns or business licenses. If the business ceases operations but funds remain in the Solo 401(k), the plan may need to be terminated or rolled over into another qualified account to remain compliant.

Contribution Limits

Solo 401(k) plans allow for substantial retirement savings due to their dual contribution structure. As both an employee and employer, the account holder can contribute in two ways: elective deferrals and employer profit-sharing contributions.

For 2024, employee contributions can be up to $23,000, or $30,500 for those aged 50 and older due to the catch-up provision. These contributions can be pre-tax or Roth.

Employer contributions depend on the business structure. Sole proprietors, single-member LLCs, and partnerships can contribute up to 20% of net earnings from self-employment, calculated after deducting self-employment taxes. S corporations and C corporations can contribute up to 25% of W-2 wages paid to the owner. When combined with employee deferrals, total contributions cannot exceed $69,000 in 2024, or $76,500 with catch-up contributions.

Timing also affects contributions. Employee deferrals must be elected by December 31 of the tax year, but deposits can be made until the personal tax filing deadline, including extensions. Employer contributions follow the business tax return deadline, which varies by entity type. Sole proprietors have until April 15, or October 15 with an extension, while S corporations must adhere to the March 15 or September 15 deadlines.

Plan and Compliance Documents

A Solo 401(k) requires proper documentation and adherence to regulatory requirements. The adoption agreement and plan document define the rules governing contributions, distributions, and investments. These documents must align with IRS and Department of Labor regulations and be updated periodically to reflect legislative changes such as those introduced by the SECURE Act and SECURE 2.0 Act. Failure to maintain current documents can result in plan disqualification and adverse tax consequences.

Recordkeeping is essential. Transactions, including contributions, rollovers, and distributions, must be documented. Roth and pre-tax contributions must be tracked separately to avoid tax misreporting. If participant loans are permitted, records must ensure compliance with the maximum loan limit of $50,000 or 50% of the account balance, whichever is lower, as outlined in IRC Section 72(p). Loan defaults trigger taxation and potential penalties, making accurate recordkeeping critical.

Errors That Affect Qualification

Mistakes in plan administration or documentation can jeopardize a Solo 401(k)’s qualified status, leading to tax penalties and potential disqualification. Common errors include exceeding contribution limits, failing to follow distribution rules, and not filing required forms.

Improper contribution calculations are a frequent issue. Since contributions are based on earned income, misreporting self-employment earnings or W-2 wages can result in excess contributions. If not corrected promptly, these excess amounts may be subject to a 10% excise tax under IRC Section 4973.

Failing to take required minimum distributions (RMDs) once the account holder reaches the applicable age can lead to a 25% penalty on the amount that should have been withdrawn. This penalty can be reduced to 10% if corrected within two years.

Administrative oversights, such as failing to file Form 5500-EZ when required, can also affect qualification. The IRS imposes penalties of $250 per day, up to $150,000, for late filings. Additionally, failing to maintain up-to-date plan documents to reflect regulatory changes can result in plan disqualification. If errors occur, the IRS offers the Employee Plans Compliance Resolution System (EPCRS), which provides methods for self-correction or formal filings to remedy compliance failures before they escalate.

Impact on Tax Filings

A properly maintained Solo 401(k) provides tax advantages, but errors or mismanagement can lead to unexpected liabilities. Contributions reduce taxable income, but incorrect reporting can trigger IRS audits or penalties. Plan sponsors must ensure that contributions are accurately deducted on the appropriate tax forms, such as Schedule C for sole proprietors or Form 1120-S for S corporations.

Distributions must also be reported correctly. Pre-tax withdrawals are subject to ordinary income tax and, if taken before age 59½, may incur a 10% early withdrawal penalty unless an exception applies under IRC Section 72(t). Roth Solo 401(k) distributions, if qualified, are tax-free, but improper recordkeeping can cause misclassification, leading to unnecessary taxation. Additionally, loan defaults from the plan are treated as taxable distributions, increasing the account holder’s tax burden.