- To be eligible for a solo 401k, you must not have any full-time W-2 employees that work over 1,000 hours per year.
- Hiring a full-time W-2 employee disqualifies you from your solo 401k plan. You’re given up to one year after the new employee starts working to terminate or upgrade your solo 401k.
- You could choose to upgrade your solo 401k into a traditional 401k plan to include your new full-time hire. Or, you could terminate your plan and rollover all funds and assets into an IRA.
- You are still allowed to hire part-time employees who work less than 1,000 hours per year, 1099 contractors, employees under 21 years old, union employees, and non-resident alien employees.
There are only two eligibility requirements for a solo 401k:
- You must have self-employed business activity.
- You must not have any full-time employees that work more than 1,000 hours per year in your business (excluding your spouse).
Business owners with any type of business entity can open a solo 401k as long as they generate income and they don’t have employees.
But what happens if you decide to hire a full-time W-2 employee, and you’re no longer self-employed? Can you keep your account, or does it get closed automatically?
This guide explain what happens to your solo 401k account eligibility when you hire a full-time employee, and the proper actions to take to upgrade or terminate your account.
The no-employees rule explained
The solo 401k no-employee rule doesn’t mean that you can’t hire anyone to help you with your business. Only full-time W-2 employees of your company who work more than 1,000 hours would disqualify you from the solo 401k plan.
The following types of employees are still permitted:
- Employees under 21 years old
- Part-time employees
- 1099 contractors
- Union employees
- Nonresident alien employees
Remember that the only exception to the no-employee is your spouse. They are allowed to work as full-time W-2 employees of your business, even if they work over 1,000 hours per year.
Are part-time W-2 employees allowed if they work under 1,000 hours per year?
Yes. If you hire a W-2 employee, and they work under 1,000 hours per year, you are still eligible to contribute to a solo 401k.
However, there’s a change coming in 2024 that you should keep note of.
In the past, you could get around the no-employee rule by just hiring a part-time employee and having them work under 1,000 hours per year. Some employers would choose to let part-time employees work anywhere between 500 to 999 hours per year and they would still be qualified for a solo 401k.
However, starting in 2024, any W-2 part-time employee that works at least 500 hours in your business for 3 consecutive years would disqualify you from the plan. Although the change doesn’t come into effect until 2024, once it does, the 3 years would get counted starting from January 1, 2021.
What happens to my solo 401k account if I hire an employee?
When you hire a full-time employee, your lose your solo 401k eligibility. The good thing is, you can exclude them from your plan for up to one year of employee service. In other words, you get until one year AFTER the employee starts working for you to transition your solo 401k account.
There are two options you can take:
- Upgrade your solo 401k into a full 401k plan to include your new employee.
- Terminate your solo 401k and rollover your funds and assets to an IRA.
Upgrading your solo 401k into a full 401k
Not many employers will choose this route. It’s more expensive, and brings a ton more administrative work into play.
You’ll have to file a lengthy 5500 return, perform non-discrimination testing, get outside administration help from a 3rd party, and obtain a surety bond for liability exposure. In addition, a 401k has restrictions on what they can allow as investments. You’ll have to set up your 401k plan to decide if it will allow non-traditional investments, and follow a new set of 401k rules that you didn’t have with a solo 401k.
Terminating your plan and rolling over to an IRA
The more common choice is to terminate the solo 401k and rollover the funds and assets to an IRA plan. You could rollover your funds and assets into a self-directed IRA. Rollovers are not taxable events and you shouldn’t need to pay any taxes for completing a rollover.
Unlike a 401k, an IRA is an individual account and not tied to your company. Therefore, it has no rules around hiring employees. To fully terminate your solo 401k, notify your solo 401k plan provider, rollover all your funds/assets, then file Form 5500-EZ. The deadline for Form 5500-EZ is 7 months after your fiscal year ends. Do not miss the due date as the penalties are extremely steep. You can learn more about the 5500-EZ here.
If you hire a full-time W-2 employee, your solo 401k becomes disqualified. You have a year after they start working to decide what to do with your solo 401k account.
You can either upgrade your solo 401k into a traditional 401k account and include your employee. Or, you can terminate your solo 401k, and rollover all of your funds and assets into an IRA. Rollovers are more common than upgrading to a traditional 401k, which requires more paperwork and administration for setting up and maintaining the plan.
Alternatively, you could look into sponsoring a SEP IRA or SIMPLE IRA for your company.
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