Hiring Your First Employee: Tax Obligations, Payroll Setup, and the Solo 401(k) Impact

The transition from solo operator to employer is the most significant administrative and tax change a small business owner makes. Hiring the first W-2 employee triggers a cascade of new obligations: federal payroll tax withholding and deposits, state payroll tax withholding, workers’ compensation insurance (required in most states), federal and state unemployment insurance (FUTA/SUTA), and changes to the retirement plan (the Solo 401(k) is no longer available). The additional cost of employing a $35,000/year worker is $5,000-$8,000 beyond the salary, depending on the state.

What’s the true cost of the first employee?

What happens to the Solo 401(k)?

The Solo 401(k) is available only to business owners with no common-law employees (other than a spouse). Hiring one W-2 employee, even part-time, eliminates eligibility. The business owner must transition to a plan that covers the employee:

Options after hiring:

• SIMPLE IRA: Lower deferral ($16,000 vs $23,500), lower employer cost (match up to 3% of compensation).
• SEP IRA: Employer-only contributions, uniform percentage for everyone.
• Safe Harbor 401(k): Higher deferral ($23,500), mandatory 3% non-elective or 4% match on all eligible employees, higher administration cost ($1,500-$3,000/year TPA).

The transition must happen by the plan year-end. If the owner hires an employee in June, the Solo 401(k) remains valid for the year IF the employee does not meet the plan’s eligibility requirements (typically 1 year of service and 1,000 hours). If the employee meets eligibility immediately, the Solo 401(k) must be terminated and a new plan established.

What happens if I contribute more than the allowed limit to my retirement plan?

Excess contributions are subject to a 6% excise tax each year they remain in the account (IRC 4973 for IRAs, IRC 4979 for 401(k) plans). For IRAs, you can withdraw the excess plus attributable earnings before the tax filing deadline (including extensions) to avoid the penalty for that year. For solo 401(k) plans, excess deferrals must be corrected by April 15 of the following year. Excess employer contributions can be corrected through plan amendment. The contribution limits are aggregate across all plans of the same type, so if you contribute to both an employer 401(k) and a solo 401(k), the employee deferral limit is shared.

How do I choose the right tax professional for my business?

Look for a CPA or EA (Enrolled Agent) with specific experience in your industry and business structure. General tax preparers who primarily handle W-2 returns may miss business-specific deductions and planning opportunities. Ask about their experience with your entity type (S-Corp, partnership, sole proprietorship) and whether they handle estimated tax calculations, payroll tax compliance, and state filing requirements. A proactive tax advisor will schedule a mid-year planning session to project your annual liability and recommend adjustments, not just file your return after the year ends. Fee structures vary: hourly rates, flat fees per return, or monthly retainers. For businesses with multiple entities, multi-state obligations, or complex transactions, a monthly retainer with a dedicated advisor often provides the best value.

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.