By: Scott Cloud, MBA, CPC

Arguably the most common mistake made with small business retirement plans is the selection of “immediate eligibility/no waiting period” when drafting a SEP or Solo 401(k) plan document for a self-employed individual without any employees.  The consequences of doing so can be disastrous for the business owner and a nightmare for an advisor or CPA who had helped to coordinate the completion of the plan document.

The Issue

Contrary to what some believe or expect, neither SEP nor Solo 401(k) plan documents include language that limits eligibility/participation to the business owner.  If “immediate eligibility” is selected – and if the business owner later hires an employee – that employee will become eligible for the plan immediately on their date of hire.  Any employee who is eligible for an employer-sponsored retirement plan is covered under the provisions/selections in the plan document.  With most SEP and Solo 401(k) plan documents, an eligible employee is entitled to the same contribution as a percentage of gross W-2 wages that the business owner contributed to the plan for themselves.  (For self-employed individuals who don’t pay themselves W-2 wages, the denominator is generally Net Schedule C Earned Income.)

Business owners often don’t inform their financial advisor or CPA of a new hire at the time it happens, and it sometimes isn’t communicated until well into the next year when tax reporting starts (which for extenders can be as late as August or even September).  By that time, the contribution to the SEP or Solo 401(k) Plan has already been made, which – under the terms of the plan document – entitles the employee to the same contribution that the business owner gave themselves as a percentage of W-2 wages or Net Schedule C Earned Income.  In some cases, it isn’t discovered until years later that an employee has been eligible for the plan since their date of hire.

The Potential Consequences

Failure to make contributions under the terms of a qualified retirement plan document is susceptible to discovery in an IRS audit.  If “immediate eligibility” was selected in the plan document but contributions were not made to an employee, the IRS will require the business owner to make back-contributions to the employee (adjusted for lost investment earnings), which can total into the tens of thousands of dollars.  Redrafting a plan document and back-dating it to conform with the business owner’s actual intent is a form of tax fraud and should never be considered.

In addition, most Solo 401(k) plan documents apply the inflexible “pro-rata” profit sharing allocation method, which cannot be amended mid-year without violating anti-cutback rules.  If a new employee’s eligibility for a Solo 401(k) plan isn’t discovered until their second calendar year of employment, the business owner must therefore wait until the following year (i.e., the employee’s third calendar year of employment) to convert to a much more favorable arrangement with “cross-tested” profit sharing and/or with a cash balance plan alongside the 401(k) plan.

The Solutions

SEP and Solo 401(k) plan documents should always be drafted to apply the longest and most restrictive eligibility requirements in order to give the business owner as much time as possible to consider changes to the plan design (or plan type) in light of the fact that a new employee will become eligible. The plan can always be amended at a later time to let a new hire into the plan sooner, if necessary.  If the business owner themselves has not yet satisfied the eligibility requirements, most plan documents include an option to waive the eligibility requirements for anyone who was hired on or before the plan’s effective date.

If a self-employed individual currently has a SEP or Solo 401(k) plan with “immediate eligibility” selected – and if there’s even a remote possibility that they’ll hire an employee in the future – they should consider amending/restating the plan document now to apply the longest and most restrictive eligibility requirements possible.

It is also recommended that a business owner without any employees be instructed to notify their financial advisor and CPA if they plan to hire any employees so that it can be determined whether changes to the retirement plan design (or plan type) are necessary.


When completing a SEP or Solo 401(k) plan document, business owners, financial advisors, and CPAs often select “immediate eligibility” without considering the consequences of doing so if the business owner later hires an employee.  At best, this can result in the business owner being stuck with a retirement plan with very unfavorable terms for at least one year (and often for two years if the new hire’s eligibility isn’t discovered until sometime into their second calendar year of employment).  At worst, the business owner can be required to make significant back-contributions for one or more eligible employees who should have received contributions under the plan but didn’t.  By instead selecting the plan document’s longest and most restrictive eligibility requirements, the business owner will have as much time as possible to determine changes to the retirement savings program in preparation for one or more employees becoming eligible.