Can I have a solo 401(k) with employees? I came across a version of this question on social media and reached out to our resident expert on all things related to retirement plans: Konstantin Litovsky of Litovsky Asset Management. I have worked with Kon for years and have great respect for his depth of knowledge. Kon is a valued sponsor of this blog and was kind enough to write a guest post on the subject. Let’s find out what he has to say!
Can I have a solo 401(k) with employees?
The question: “I’m a solo physician with one part-time employee. Am I able to open a solo 401k since the employee doesn’t work long enough hours to qualify to contribute to the retirement plan? Or does it have to be a “group” plan into which only I get to contribute since the other employee is not eligible to contribute?”
Define “part-time”
For retirement plan purposes the term ‘part time’ is meaningless since the employee would be
eligible after they’ve worked for 1 year and 1000 hours.
Also, if this is a long-time part-time employee, they might be eligible to join a plan if they work at least 500 hours in 3 consecutive years.
Define “solo 401(k)”
However, since by ‘solo 401k’ most people imply an off-the-shelf product that is offered by major brokerages,
typical eligibility for participation is also meaningless because most such ‘solo 401k’ products have a plan document that cannot be customized the way a typical 401k plan document can be.
The Problem
An individual 401k plan is not a plan you want to have when you have any non-spouse employees. A
major issue is that the individual 401k plan document in many cases does not allow you to change the terms
of the document, and there is usually immediate eligibility for all participants (for example, this is what
Vanguard has in their plan document).
This means that your employee will be immediately eligible with no minimum eligibility requirement! This will create a problem because they will also be eligible to get up to 25% profit sharing (or the same percentage as the owner).
A workaround?
There are some individual 401k plan documents that can be modified to exclude those working under 1000 hours, but I would still be very wary of all of the other plan provisions that have to be properly selected to make sure that the employee is not in the plan right away at full employer contribution.
For this reason, unless one is an expert, I would not recommend an individual 401k with a non-spouse employee because it is very easy to violate your plan document provisions and miss something (such as an employee becoming eligible to join the plan).
Once the employee becomes eligible, this becomes an ERISA plan. One way to set up an individual 401k with a custom plan document is by using a service provider such as mysolo401k.net for example, and this might be a better option than opening a full-blown ERISA plan with a record-keeper if you anticipate hiring an employee. This is a type of plan that is customized for the owner with the help of mysolo401k.net.
At some point, if/when the employee becomes eligible this might not be good enough as these are brokerage only plans where everyone opens their own self-directed account, so once an employee is eligible to participate, you would have to spend the time to get them set up and oriented, which in and of itself can be an issue because you are a fiduciary who is responsible for all aspects of your plan, and this will incur significant liability that you wouldn’t otherwise have if you had an ERISA plan set up.
Best option: ERISA Plan
Hence, using a custom plan document provider is still the best way to go if you anticipate hiring employees. At least during the year when they are eligible you can consider switching to an ERISA 401k plan with a TPA and a record-keeper, and this will give you options vs. setting up an individual 401k plan, where as soon as you hire an employee, they become eligible, and you would be on the hook for making full contribution for them (and you would still need to switch to an ERISA plan regardless as off-the-shelf individual plans cannot accommodate eligible employees, and it is explicitly stated in the plan document that these plans are for owner and spouse only).
I hope this helps! Pen down any questions or comments you have down here.