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 account 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.
Editor's note: The
preceding discussion should not be interpreted as tax, legal or estate
planning advice.
You should consult with your specific tax, legal or
estate planning professional for guidance relating to your specific
circumstances.
Eric Sewell has worked in public accounting since
1997, has a BS in Accounting from George Mason University, is a member
of the American Institute of CPAs, Virginia Society of CPAs, National
Association of Enrolled Agents, and the National Association of Tax
Professionals.
He resides in Fairfax, Va. with his wife and two
children and may be reached with questions and comments via
www.EricSewell.com.
