Plan Now to Take Advantage of the One Person 401(k) - Part 1 - Overview of the Strategy

In March, we looked at the benefits of establishing a Simplified Employee Pension ("SEP") prior to the extended due date of the 2008 return (generally October 15, 2009). [See "It's Not Too Late to Reduce Your 2008 Taxes: Establish a Simplified Employee Pension."] By establishing the plan AFTER year end, you can generate tax deductions for the previous year (i.e., 2008). In this post, you will learn that if you take action BEFORE year end, you can significantly increase the amount of money that can be set aside for retirement. If you are self-employed and you currently use a SEP to make retirement plan contributions, you may want to determine whether it would be more beneficial to use a one person 401(k) plan instead.

 

A 401(k) plan is a profit-sharing plan designed to receive employer contributions and employee salary deferral contributions. The employee elects to defer a portion of his or her compensation by having it deposited directly into the plan. The deferrals are treated as tax-deductible employer contributions that are not taxable to the employee until distributed by the retirement plan. In the case of a self-employed individual, the employee is both the employer and the employee.

 

There are two reasons why after the changes made by 2001's Economic Growth and Tax Relief Reconciliation Act ("EGTRRA") one-person 401(k) plans provide significant benefits to the self-employed individual. First, EGTRRA added IRC Section 404(n). Before EGTRRA, salary deferral contributions were included in determining the maximum amount an employer could contribute annually to defined contribution retirement plans as matching or profit-sharing contributions; thus, employee salary deferrals and employer contributions limited each other. As a result of the changes to Section 404(n), enacted by EGTRRA, salary deferrals are not included in determining the deduction limits of Section 404(a)(3). Second, is the addition of IRC Section 415(c)(1). EGTRRA changed this limit to the lesser of 100 percent of compensation or $49,000 (beginning in 2009), which is adjusted annually by the Treasury for cost-of-living increases.

First, the elective deferral limitation provides the self-employed individual can contribute up to 100% of his or her compensation up to a limit of $16,500 for 2009. This elective deferral is excluded from the self-employed individual's taxable income, which equates to a deduction. For individuals age 50 or over by the calendar year-end, an additional $5,500 (for 2009) “catch-up” contribution is allowed. This limitation applies globally to all 401(k), 403(b), SIMPLE IRA, and SEP plans in which an individual participates. As a result, the individual can defer a total of $16,500 (or $22,000 of age 50 or older) combined for all plans that permit such deferrals. For example, assume a 40-year-old participant makes a 2009 elective deferral contribution of $6,500 to his full-time employer’s 401(k) plan. That reduces the maximum elective deferral contribution to the one-person401(k) set up for his or her side business dollar for dollar, making that amount only $10,000 or $15,500 if age 50 or older ($16,500 global maximum minus $6,500 or $22,000 global maximum minus $6,500 if 50 or older.

 

Second, the employer deduction limitation provides the employer can contribute up to 25% of the employee-owner's compensation. This contribution is treated as a profit-sharing plan (or employer contribution). In calculating the allowable employer contribution, the owner’s elective deferrals are not counted towards the 25% deduction limit. When calculating a self-employed individual’s limitation, compensation is defined as net self-employment earnings less the deduction for half of the self-employment (SE) tax and after a reduction for the individual’s own contribution. This latter reduction requires using a simultaneous equation that effectively reduces the self-employed participant’s maximum contribution percentage to 20%.

 

Third, the annual addition limitation provides that the combined elective deferral (step 1) and the employer contribution (step 2) may not exceed the lesser of 100% of the self-employed individual's compensation or $49,000. The $5,500 catch-up contributions for individuals age 50 or over by the calendar year-end are not included in the annual additions limitation (step 3). Similar plans of the employer and any related employer must be aggregated in determining the limit. However, if an employee receives benefits from unrelated employers, there is a separate annual addition limit for each unrelated employer.

 

Putting all of these limitations together, a self-employed individual can receive an employer contribution of up to 25% of compensation and make a salary deferral contribution of up to $16,500 ($22,000 if age 50 or over), as long as the total does not exceed the lesser of 100 percent of compensation or $49,000 ($54,500 if age 50 or over). In addition, if the individual is also employed by one or more unrelated employers, he or she can receive multiple employer contributions (i.e., equal to amounts up to 25% of compensation limited to an amount that does not exceed $49,000 ($54,500 if age 50 or over). In other words, the individual can receive a full contribution from an unrelated employer (actually any number of unrelated employers provided the compensation is reasonable) for whom he or she holds a full time job and he or she can get a full contribution from his or her own (or spouse's) side business. However, as previously discussed, the individuals elective deferrals are combined and subject to a single $16,500 ($22,000 if age 50 or over) limitation.

 

In addition to higher contributions one person 401(k) plans offer several additional benefits over SEPs. First, loans are permitted (provided they are allowed by the plan) limited to the lesser of 50% of the account balance or $50,000. Second, if the individual is a participant in another 401(k) plan and his or her elective deferrals are limited under the nondiscrimination tests (which generally reduce the amount of elective deferrals that can be made by so-called highly compensated employees), then he or she should be able to contribute the difference between the $16,500 or $22,000 limitation and the amount allowed under the coverage tests to the one person plan.  That plan should not be similarly limited since the discrimination tests generally should not apply (i.e., employees limited to sole owner and spouse).

 

If a business employs someone other than the owner, 401(k) contributions may be required for those employees. However, it is permissible to exclude from coverage any employee who is either under age 21 or has worked fewer than 1,000 hours during any 12-month period. Thus, young and part-time employees (including the owner’s spouse and children, if applicable) need not cause complications for what is intended to be a 401(k) covering only the owner. On the other hand, it may be even more beneficial to find a way to employ the owner's spouse and extend plan coverage to the spouse because the married couple may be able to make an additional contribution of up to $49,000 ($54,000) if this other spouse otherwise was not employed or covered by a qualified plan.

 

Lets look at how a one person 401(k) stacks up to the SEP we established for our individual with $20,000 of director's fees in my March 31 post assuming such individual had not attained age 50 as of the end of 2008. Note the elective deferral limitation for 2008 was $15,500 ($20,500 if age 50 or older); the annual addition limitation for 2008 was $46,000 ($51,000 if age 50 or older).  

                                

	One Person
		401(k)	SEP
Step 1 - Elective Deferral		$  15,500	$0
Step 2 - 20% (25% limited reduced for simultaneous deduction) of $20,000 less 50% of self-employment tax		$    3,942	$3,942
Allowable Contribution		$  19,442	$3,942

 

After the $19,442 contribution is made to the one person 401(k), the individual's self employment income from the director's fees is $268 [$20,000 - $19,442 - $290]. In other words, all but $268 of the director's fees is sheltered. In the case of the SEP, the individual's self-employment income is $15,768 [$20,000 - $3,942 - $290]. As you can see, there is a significant benefit to using a one person 401(k) over a SEP.

 

If the benefits of using a one person 401(k) are so superior, why not use the 401(k)? The reason is that a 401(k) plan MUST be established (but not funded) before year end. Thus, if the one person 401(k) was not established last year, it cannot be used for 2008. In this case, we suggest the individual use a SEP for 2008 and then roll the SEP balance into a one person 401(k) in 2009.

 

In my next post, we'll look at what happens when the individual is age 50 and elects to make $5,000 catch up contribution for 2008. An additional $5,000 deduction would cause the individual to have a loss from self-employment income.