Timing of solo 401(k) contributions if adding employee mid year

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sandtiger steve
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Timing of solo 401(k) contributions if adding employee mid year

Post by sandtiger steve »

Hello, I have looked everywhere for this answer but can't seem to find it.

I have a solo 401K plan and added an employee mid last year, who has one year to be eligible for the plan (at which point the plan needs to be closed).

So last year I was able to make a full contribution but will have to close the plan in 2022 by June.

My question is, between now and June am I allowed to make a full contribution for that year, both as employee and employer? And if so, for the employer contribution, is the full year 2022 income used for the calculation of the allowable amount, or some pro-rata number?

Thanks for any guidance
SS
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sandtiger steve
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by sandtiger steve »

Bump!
SuzBanyan
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by SuzBanyan »

For your employee deferral, you should be able to take the full amount of deferral for the year, even if you terminate half way through. This is consistent with W-2 employees covered by a 401k for just part of a year. This assumes that such amount is allowable based on your selfemployment income through Teri inaction of your 401k

For the employer contribution, I can’t see how you can take more than that allowable based on your self-employment earnings through plan termination.
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cowdogman
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by cowdogman »

Assuming the profit associated with the business thru the last day of the plan supports a full deferral ($20,500 for 2022) + catch up if relevant, then you should be able to make those deferrals.

For the employer contribution, I am pretty sure it should be based on the profit only thru the last day of the plan. But I am not 100% sure.

MUCH MORE IMPORTANTLY, are you planning to terminate and replace the plan? If so, you need to look very carefully at the successor plan rule.

P.S., I've assumed you're a schedule C filer, not S corp.
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sandtiger steve
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by sandtiger steve »

Thanks for that. Yes I agree it makes sense I should be able to make the full employee deferral, and then the employer deferral is a question mark -- depending on the dates of income that can be used for that calculation. I can't find any IRS document that describes how this works. Any thoughts?

And then yes at the employee hire + 1 year mark I need to close the plan (or I guess just not make more contributions). Also unclear if I roll it into an IRA etc. And yes Schedule C LLC

Thanks again for thoughts
SS
SuzBanyan
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by SuzBanyan »

Here is some information about transitioning to a new plan from guru Spirit Rider in a 2019 post concerning a business with a solo 401k at Fidelity who hired an employee on 1/1/19:

“Only if you elected a one (1) year service requirement with 1,000 hours/year, before an employee was hired. An employee hired effective 1/1/2019 who worked >= 1,000 hours during 2019 would not become eligible until 1/1/2020.

This would mean that the one-participant 401k can exist for the 2019 tax year. You can make your full contributions and the employee is not eligible for this year.

If you did not elect the employee eligibility restrictions before they were hired, they became eligible the day they were hired and your one-participant 401k was in non-compliance.
The Fidelity CSR is correct. There is a 401k successor plan rule. You can not adopt another 401k plan for one (1) year after you terminate a previous 401k plan.
You can either freeze* the one-participant 401k plan and adopt a new small business safe harbor 401k plan or amend the one-participant 401k plan to a small business safe harbor 401k plan.

Another alternative is to terminate the one-participant 401k plan, rollover the assets to a rollover IRA and adopt a SIMPLE IRA plan for 2020. The successor plan rule does not apply to a follow-on SIMPLE IRA plan.

Keep in mind that the notice requirements for a safe harbor 401k plan is 30 - 90 days and a minimum of 60 days for a SIMPLE IRA.

You would need to have a SIMPLE IRA ready to go and provide notice/enrollment information no later than 11/2/2019 for a 1/1/2020 start. You would need to have a safe harbor 401k ready to go and provide notice/enrollment information no later than 12/2/2019 for a 1/1/2020 start.

*Assuming Fidelity allows freezing their Self-employed 401k”

The thread is here: viewtopic.php?t=292019
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cowdogman
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by cowdogman »

SuzBanyan wrote: Thu Jan 13, 2022 1:34 pm You can not adopt another 401k plan for one (1) year after you terminate a previous 401k plan.
The successor plan rule does not prohibit you from establishing a new 401(k).

The successor plan rule prohibits you from removing any assets from the previous plan other than on "death, disability, or severance from employment" or you reach 59.5 YO.
A distribution may not be made under paragraph (d)(1)(iii) [termination of plan] of this section if the employer establishes or maintains an alternative defined contribution plan. For purposes of the preceding sentence, the definition of the term “employer” contained in § 1.401(k)-6 is applied as of the date of plan termination, and a plan is an alternative defined contribution plan only if it is a defined contribution plan that exists at any time during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan.
26 CFR § 1.401(k)-1(d)(4)--https://www.law.cornell.edu/cfr/text/26/1.401(k)-1

So, if you are willing to leave the assets in the current 401(k) until "death, disability, or severance from employment" or you reach 59.5 YO then you can establish a new plan immediately. Where most people get in trouble is terminating a plan, rolling the amount to an IRA and then starting a new 401(k) plan within 12 months. The consequences of doing so are (1) the rollover is immediately taxable and (2) the IRA is "contaminated" and the entire balance of the IRA may be found to be immediately taxable.

The purpose of the Successor Plan Rule is to prevent participants from getting around the prohibitions on distributions (except in limited circumstances) by terminating a plan, distributing its assets and then starting a new plan.

Be careful.
SuzBanyan
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by SuzBanyan »

cowdogman wrote: Thu Jan 13, 2022 1:52 pm
SuzBanyan wrote: Thu Jan 13, 2022 1:34 pm You can not adopt another 401k plan for one (1) year after you terminate a previous 401k plan.
The successor plan rule does not prohibit you from establishing a new 401(k).

The successor plan rule prohibits you from removing any assets from the previous plan other than on "death, disability, or severance from employment" or you reach 59.5 YO.
A distribution may not be made under paragraph (d)(1)(iii) [termination of plan] of this section if the employer establishes or maintains an alternative defined contribution plan. For purposes of the preceding sentence, the definition of the term “employer” contained in § 1.401(k)-6 is applied as of the date of plan termination, and a plan is an alternative defined contribution plan only if it is a defined contribution plan that exists at any time during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan.
26 CFR § 1.401(k)-1(d)(4)--https://www.law.cornell.edu/cfr/text/26/1.401(k)-1

So, if you are willing to leave the assets in the current 401(k) until "death, disability, or severance from employment" or you reach 59.5 YO then you can establish a new plan immediately. Where most people get in trouble is terminating a plan, rolling the amount to an IRA and then starting a new 401(k) plan within 12 months. The consequences of doing so are (1) the rollover is immediately taxable and (2) the IRA is "contaminated" and the entire balance of the IRA may be found to be immediately taxable.

The purpose of the Successor Plan Rule is to prevent participants from getting around the prohibitions on distributions (except in limited circumstances) by terminating a plan, distributing its assets and then starting a new plan.

Be careful.
You may be right. As noted in my quote from Spirit Rider above, he thought that if you could freeze the old plan, you could start a new small business plan to include your employee. Or amend the solo plan to make it a small business plan.

I think what the plan owner can’t do is nothing, because the solo plan would then automatically cover the employee and be non-compliant.
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cowdogman
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by cowdogman »

sandtiger steve wrote: Thu Jan 13, 2022 12:17 pm Thanks for that. Yes I agree it makes sense I should be able to make the full employee deferral, and then the employer deferral is a question mark -- depending on the dates of income that can be used for that calculation. I can't find any IRS document that describes how this works. Any thoughts?
I think this will be governed by your plan (all 100+ pages of it), primarily thru the definition "Plan Year." If you terminate in June you will have a "short Plan Year" for 2022.

You may also want to look at "Plan Year" references in I.R.C. § 401 (https://www.law.cornell.edu/uscode/text/26/401) and 26 CFR § 1.401(k)-1 (https://www.law.cornell.edu/cfr/text/26/1.401(k)-1).
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cowdogman
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by cowdogman »

SuzBanyan wrote: Thu Jan 13, 2022 2:19 pm
cowdogman wrote: Thu Jan 13, 2022 1:52 pm
SuzBanyan wrote: Thu Jan 13, 2022 1:34 pm You can not adopt another 401k plan for one (1) year after you terminate a previous 401k plan.
The successor plan rule does not prohibit you from establishing a new 401(k).

The successor plan rule prohibits you from removing any assets from the previous plan other than on "death, disability, or severance from employment" or you reach 59.5 YO.
A distribution may not be made under paragraph (d)(1)(iii) [termination of plan] of this section if the employer establishes or maintains an alternative defined contribution plan. For purposes of the preceding sentence, the definition of the term “employer” contained in § 1.401(k)-6 is applied as of the date of plan termination, and a plan is an alternative defined contribution plan only if it is a defined contribution plan that exists at any time during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan.
26 CFR § 1.401(k)-1(d)(4)--https://www.law.cornell.edu/cfr/text/26/1.401(k)-1

So, if you are willing to leave the assets in the current 401(k) until "death, disability, or severance from employment" or you reach 59.5 YO then you can establish a new plan immediately. Where most people get in trouble is terminating a plan, rolling the amount to an IRA and then starting a new 401(k) plan within 12 months. The consequences of doing so are (1) the rollover is immediately taxable and (2) the IRA is "contaminated" and the entire balance of the IRA may be found to be immediately taxable.

The purpose of the Successor Plan Rule is to prevent participants from getting around the prohibitions on distributions (except in limited circumstances) by terminating a plan, distributing its assets and then starting a new plan.

Be careful.
You may be right. As noted in my quote from Spirit Rider above, he thought that if you could freeze the old plan, you could start a new small business plan to include your employee. Or amend the solo plan to make it a small business plan.

I think what the plan owner can’t do is nothing, because the solo plan would then automatically cover the employee and be non-compliant.
Yes, it's a tricky issue. Also, if the OP terminates he needs to file a 5500-EZ, but a 5500-EZ requires a zero plan asset balance at the time of filing. So, somehow letting the first plan go into hibernation, leaving the assets in that plan and then (if he wants) starting a new plan. Probably makes sense for the OP to get some pro advice if he wants to start a new plan within 12 months.
Topic Author
sandtiger steve
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by sandtiger steve »

Yes I would want to start a new plan; the one I have my eye on is a profit sharing "new comparability" plan. This seems to afford the best level of contribution if not solo.

Based on the above it seems that the best strategy is to freeze the Solo plan.

Thanks for the help
SuzBanyan
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Re: Timing of solo 401(k) contributions if adding employee mid year

Post by SuzBanyan »

sandtiger steve wrote: Thu Jan 13, 2022 5:30 pm Yes I would want to start a new plan; the one I have my eye on is a profit sharing "new comparability" plan. This seems to afford the best level of contribution if not solo.

Based on the above it seems that the best strategy is to freeze the Solo plan.

Thanks for the help
Obviously, you want to make sure that the company who has your current Solo 401k allows you to freeze your current plan.
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