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Individual 401(K) Plans

A 401(k) Plan is a defined contribution profit sharing plan which provides for contributions to be made pursuant to a “cash or deferred arrangement” (CODA) under which individual participants elect to take amounts in cash (i.e. receive all of their salary or wages) or to have some of their earnings directed into the 401(k) Plan. Amounts deferred into the Plan are excluded from the participant’s taxable income for the year and grow tax-deferred, similar to assets in other retirement savings plans. Employers may also offer to match a portion of employee elective deferrals to the plan by making additional, discretionary contributions to an employee’s account.

Individual 401(k) Plans

The term “Individual 401(k)” (also called “Solo” or “Uni” plans) is generically used most often to describe the combination of a Profit Sharing or Defined Benefit Plan combined with a 401(k) Plan by solo practitioners. Prior to 2001, there was no reason for a self-employed individual to have a 401(k) plan. An owner-only business could contribute as much or more to a straight Profit Sharing or SEP-IRA as they could to a 401(k), which was more costly to administer.

Now, however, the advantage may have swung the other way. The Economic Growth and Tax Relief Reconciliation Acts of 2001 (EGTRRA), while not explicitly creating new Individual 401(k) Plans, did change the rules governing traditional 401(k) and pension plans, making 401(k)’s suddenly more attractive for the self-employed or one-person corporation. To understand why an Individual 401(k) Plan may be beneficial to a self-employed individual, let’s review some of the differences between the old and new rules.

First, under the old rules, per Internal Revenue Code Section 404 (IRC 404), the maximum amount that a business owner could deduct as a contribution to a qualified retirement plan was 15% of total compensation or net income. This amount included both employer contributions (profit sharing and matching) and employee elective deferrals. So for any level of income, owners could effectively maximize their contribution without the need of adding a 401(k) on top of their basic pension plan.

Effective January 1, 2002, however, the rules under EGTRRA raised the maximum amount that a business owner could contribute to 25% of total compensation or income. Furthermore, this amount no longer included elective deferrals. In addition, Internal Revenue Code Section 415 (IRC 415), which dictates the maximum amount that may be allocated to one individual in a given year under a qualified retirement plan, was increased from 25% to 100% of compensation (up to a maximum compensation amount set annually), plus a “catch up” provision on elective deferrals for those age 50 and over.

The combination of these two changes meant that solo practitioners could essentially maximize their pension plan contributions at lower income levels with a combination Profit Sharing and 401(k) Plan (Individual 401(k) Plan) than with the Profit Sharing Plan alone. Let’s take a look at an example.

Example: Self-Employed Individual – Incorporated

Profit Sharing contributions are limited to the lesser of 25% of compensation up to a maximum compensation of $230,000 in 2008, or $46,000. The $230,000 maximum compensation amount is indexed to inflation in future years in $5000 increments. The contribution limit will also be subject to future cost of living adjustments. In addition, elective 401(k) deferral contributions are limited to the lesser of 100% of compensation up to a maximum of $15,500 (in 2008), with a “catch up” contribution amount for those age 50 and over of $5,000.

For combination plans, the total of all contributions (employer contributions and employee elective deferrals) must be aggregated to determine the maximum amount toward the $46,000 limit. For those age 50 and over, the maximum amount is $51,000 including the $5,000 catch up provision.

The following illustrates the approximate income required in order to be eligible for the maximum contribution to a straight Profit Sharing Plan (PSP), and to a combination PSP and 401(k) Plan (Individual 401(k) Plan):

PSPIndividual 401(k)
Taxable Income$180,000$102,500
+ plus salary deferral amount$0$15,500
= Gross Income$180,000$118,000
X times employer contribution percentage25%25%
= Employer Contribution Amount$45,000$29,500
+ plus employee’s contribution amount$0$15,500
= Total Contribution (< age 50)$45,000$45,000

Notice now that with the Individual 401(k) Plan, a solo practitioner can now maximize the contribution to the pension plan with about 34% less income (highlighted in the table above) than with a simple Profit Sharing Plan.

 

Good candidates for utilizing Individual 401(k) plans are those:

  • with net business income of less than $230,000, or W-2 income of less than $184,000, and who would like to contribute more to their retirement plan than currently allowed with a straight PSP or SEP-IRA
  • who are age 50 and above, and would like to take advantage of the extra retirement savings provided with the “catch up” provisions on elective deferrals
  • whose spouse is the primary wage earner, and who would like to save on a tax-deferred basis most of their self-employment income
  • who want to maintain discretionary contributions
  • who are high savers wanting to maximize tax-deferred retirement savings

Additional Notes

  1. Solo plans are designed largely for businesses staffed by a single owner, although this can include spouses as long as they earn income from the business. A 2-partner only, unincorporated business could also qualify.
  2. Rollovers from IRAs, SEP-IRAs, KEOGHs and other retirement plan are eligible.
  3. You can combine a Defined Benefit Plan (DBP) with an Individual 401(k) to get extra annual savings. The DBP contributions do not limit the elective deferrals (or catch up amount) available in the 401(k).

Because of these advantages, and because of the interest generated in setting up these types of plans by small business owners without excessive costs or administrative hassles, several pension providers, banks and brokerage firms created prototype Individual 401(k) plans which can be adopted and administered at modest costs. We at Bingham, Osborn & Scarborough, LLC can discuss with you the relative advantages and disadvantages of these and other types of retirement savings plans and assist you in deciding upon and setting up the best plan for you and your business.

For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by Bingham, Osborn & Scarborough, LLC, please visit our website at www.bosinvest.com.

Disclosure:

This white paper is for informational purposes only and is not intended to be used as a general guide to investing or financial planning, or as a source of any specific recommendations, and makes no implied or express recommendations concerning the manner in which any individual’s account should or would be handled, as appropriate strategies depend upon the individual’s objectives. It is the responsibility of any person or persons in possession of this material to inform himself or herself of, and to seek appropriate advice regarding, any investment or financial planning decisions, legal requirements, and taxation regulations which might be relevant to the topic of this white paper or the subscription, purchase, holding, exchange, redemption or disposal of any investments.

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Opinions expressed are current opinions as of the date appearing in this material only and are subject to change. No part of this material may, without the prior written consent of Bingham, Osborn & Scarborough, LLC, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

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