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Self Employed 401(k)

Posted on Tuesday, July 13th, 2004 by

Solo 401(k) – Can you say ‘self-employed 401k ‘?

I was recently made aware of the “new type of 401(k) plan” or what has been referred to as the “Solo 401(k) .” Interested because I am a small business owner with my spouse, I did some gumshoe research. Here is what I learned:

The Solo 401(k) is not really a new plan created under the Internal Revenue Code or by legislation. Rather, the Solo 401(k) is the result of clever marketing by the financial services profession wanting to “sell” the idea of a 401(k) plan to the self-employed or sole-owners of small corporations who do not have employees other than immediate family. Having said that, the Solo 401(k) is worth considering because it offers an alternative to sole proprietors as well as sole owners of corporations without employees who want, or need, to save much more for retirement than SIMPLE plans and SEP IRAs offer.

The Solo 401(k) occurred as a result of changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Tax Act). The upside of a Solo 401(k) is considerable for the self-employed due to these changes. A Solo 401(k) can now be established to maximize contributions made by sole proprietors or sole owners without the additional costs normally associated with 401(k) plans established for a group of rank and file employees at a large corporation such as Verizon or IBM. Solo 401(k) s are free from the requirement to perform nondiscrimination testing that normally applies to traditional 401(k) plans, and can be established and administered more easily and with much less expense.

A Solo 401(k) can also be extended to cover the business owner’s spouse with the same results. It can even be converted to a Mini 401(k) to cover the owner’s immediate family members allowing several family members to get the advantages available through a Solo 401(k) .

Several changes were made by the 2001 Tax Act that now make the Solo 401(k) worth reconsidering for the small business owner and entrepreneur. First, the maximum allowable annual elective deferral limit has been increased. Second, the maximum annual amount that can be contributed by the employee and employer collectively has been increased. And third, there has been an increase in the maximum deductible contribution limit along with a change in the way the deduction limit is determined.

The increase in the percentage limit from 25 percent to 100 percent has a significant potential impact for Solo 401(k) holders. This is so because the employee-owner can receive a total contribution, taking into accounts his/her salary deferral contribution and the business contribution of up to 100 percent of before-tax compensation before exceeding the limit.

For business owners that are looking for the maximum amount to contribute to a deductible account, the Solo 401(k) cannot be beat! The reason for this: annual contributions consist of two parts ? (1) 100 percent of the maximum elective deferrals (for 2004, $13,000; $16,000 for those over 50) and (2) 25 percent of employee compensation for a corporate business owner and 20 percent of self-employment income for a sole proprietor. Let’s look at a couple of examples.

For 2004, Jane Dough, age 51, who is the sole shareholder and sole employee of Jane Dough, Inc. is paid a salary of $40,000. The maximum deductible contribution that can be made to the Jane Dough, Inc. 401(k) plan on behalf of Jane Dough is $26,000 calculated as follows: $13,000 maximum elective deferral contribution + $3,000 maximum catch-up contribution + 25 percent of $40,000 = $26,000.

For 2004, assuming the same facts as above, with the exception being that Jane Dough is the sole employee of her sole proprietorship, Jane Dough Company, the maximum deductible contribution is $32,000 calculated as follows: $13,000 + $3,000 maximum catch up contribution for being over 50 + 20 percent of 40,000 = $24,000.

Before the 2001 Tax Act, sole owners of small businesses did not set up Solo 401(k) s because they could get the same deduction by establishing an employer pay all profit-sharing plan. For comparison, if Jane Dough, Inc. established an employer pay all profit-sharing plan in 2004, the maximum deductible contribution that could be made to the plan would be around $10,000 ? a significant difference from the $26,000 discussed above as a corporation or $24,000 in the case of a sole proprietor.

Bottom line: Based on the contribution limits for SEPs and SIMPLEs for 2004, the sole owner of a business or a sole proprietor can shelter more money from taxes with a Solo 401(k) plan than with either of these plans. And that is something Jane Dough can take to the bank! So if one has an idea for a side business to supplement his/her 9 to 5 job and it gets off the ground (has positive cash flow), a Solo 401(k) may be a worthwhile consideration.


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