Lower Your Taxes! Build Your Retirement!

The One-Participant 401(k) Plan

By Gary A. Hensley, MBA, EA

Small business (self-employed) owners have an incentive to establish a 401(k) plan instead of an IRA-based plan to increase their retirement savings thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Public Law No. 107-16.  This article will focus on the rules for a one-participant plan that covers a self-employed individual (filing a Schedule C as part of their Form 1040) who has no employees.[i]

EGTRRA opened up the options for small business owners by increasing the allowable percentage of elective salary deferrals to qualified plans from 25% of compensation to 100% of compensation and by changing the effect of elective salary deferrals on the overall contribution limits for qualified plans.  A one-participant 401(k) plan cannot be established if the business has any eligible employees other than the business owners and their spouses.[ii]

For self-employed individuals, compensation is defined as net earnings from self-employment after deducting 50% of the self-employment tax and the employer contribution to the plan for the self-employed individual.[iii]  Just for clarity, in the case of a Schedule C sole proprietor, you are both the employer and the employee for the purpose of figuring your maximum 401(k) contribution.

As the employer, you can make up to a 25% contribution.  As the employee, you can make elective deferrals up to $17,500.  If you are age 50 or older, the catch-up provision raises this limit to $23,000.

Maximizing Plan Contributions

Let’s review an example of how this works:  Sarah, age 48, a successful mystery writer for several years, has a net business profit, in 2013, of $70,000.

Net business profit                              $70,000

SE tax deduction[iv]                            –   4,945                                                            Adjusted net profit                                $65,055

Employer contribution:

$65,055 x 0.20[v]                                   $13,011

Employee contribution:

Salary deferral (max)                             17,500

< 50 years old

Maximum contribution                           $30,511

Amazing!  Sarah’s profit of $70,000 will be reduced by one-half of her self-employment tax, $4,945 (entered on Form 1040, page 1, line 27) and by her employer/employee 401(k) contributions of $30,511 (entered on Form 1040, page 1, line 28).  This takes her business profit of $70,000 down to $34,544– more than a 50% reduction!  Her adjusted gross income (AGI) will be $34,544 (assuming no other income) and she will have $30,511 growing tax-deferred in her retirement account.

Assuming she is single, her standard deduction and personal exemption will drop AGI down another $10,000 leaving her just $24,544 of taxable income.  Her final income tax due?  $3,235 on a $70,000 profit.  Now, for the icing on the cake. If she had been 50 years old or older, in 2013, she could have added another $5,500 to her elective deferral (using the catch-up provision), dropping her taxable income down to $19,044 and her income tax to $2,410.  Had Sarah set up a SEP IRA plan, instead of a 401(k), her allowed retirement deduction would have been limited to $13,011.

The 401(k) plan needs to be in writing and set up no later than December 31st for calendar year taxpayers; however, the employer contribution, does not have to be made until the return due date (4/15/2014) or the extended due date (10/15/2014) if you file an extension for your Form 1040.   You can set up the 401(k) plan through a bank, credit union, insurance company or a mutual fund.  The paperwork is minimal and your annual administrative fee should be quite reasonable.

Be aware that your elective salary deferral maximum for 2013 is $17,500 ($23,000 if age 50 or older) across all active plans you participate in.  So, if you work for an employer and participate in a 401(k), 403(b), or similar plan, you must subtract the contributions you made to that plan from the $17,500 ($23,000 if age 50 or older) to determine how much is left to use in your self-employed retirement plan.  The total of employer and employee contributions cannot exceed $51,000 per employee in 2013.

The one-participant 401(k) plan provides an excellent opportunity for sole proprietors (and others) to reduce their tax bill while funding their retirement.   It’s not too late to set up your plan for 2013.  Compile your income and expense amounts at the end of November to determine this year’s profit or loss.  If you have a tidy profit, consider this strategy to bring it and your tax bill down.

[i] Self-employed, under EGTRRA, has a wider meaning than reviewed here.  The term self-employed generally includes sole proprietors, partners, and members of limited liability companies (LLCs) taxed as partnerships.  A single-member LLC, that has not elected “corporate” status, is treated as a “disregarded entity” or sole proprietorship and files a Schedule C as part of their Form 1040.  Thus, this article would pertain to such single-member LLCs.

[ii] A one-participant 401(k) is also called a Solo-k, a Solo-401(k), a Uni-k, or a Single-k.  The term itself is a misnomer because the plan may cover more than one person.  Participation is limited to a married couple who own an incorporated or unincorporated business, or the partners in a business partnership and their spouses.  Benefits cannot be provided to anyone else.

[iii] Because this is a circular computation, an equation is used to determine the allowable employer contribution rate:  the stated plan contribution rate is expressed as a decimal and then divided by the total of 1 plus the stated plan contribution rate.  For example, a 25% stated contribution rate becomes 20% (0.25 / 1.25)

[iv] [$70,000 x 0.9235 x 0.153) = $9,890 x ½ = $4,945

[v] Based on a 25% employer contribution [0.25 / (1 + 0.25)]


Retirement Savings Equals Tax Savings Using SEP

By Gary A. Hensley

A Plan for Sole Proprietors to Reduce Income Tax

So, you have had a great year in the publishing world and even after maxing out your operating expenses, you are still showing a tidy profit.  What to do?  Consider reducing that profit further by funding your personal retirement account and taking a tax deduction for it.

Simplified Employee Pension (SEP)

SEPs provide a simplified method for you to make contributions to a retirement plan for yourself and your employees (if any).  Instead of setting up a profit-sharing or money purchase plan with a trust, you can adopt a SEP agreement and make contributions directly to a traditional individual retirement account or a traditional individual retirement annuity (SEP-IRA) set up for yourself and each eligible employee (if any).

More good news!  Suppose 2012 is a very profitable year, even after taking all available deductions.  You can actually set up the SEP plan after your tax year closes (in this case, calendar 2012) and fund it until the due date of your return (including extensions).   For calendar 2012 sole proprietors, the normal due date of your return would be April 15, 2013 but with an automatic 6-month extension (using Form 4868), you would have until October 15, 2013 to set up the SEP and fund it for 2012. This is one of the few opportunities to lower your tax bill after your tax year (in this case, 2012) has ended and still get the deduction on that year’s return (2012).

With an extension filed (only if you cannot create the SEP plan and fund it by the normal due date), you would have a total of 9 1/2 months after December 31, 2012 to create and fund the plan.  That’s a lot of flexibility!  Caution: Even after you take the SEP deduction on your return, if you still owe a balance due (based on other income such as wages, interest, dividends, etc.), that amount would need to be paid with the initial return or paid with the extension request to avoid late payment penalties and interest.  The extension only allows you an extra six months to set up the SEP plan and fund it.

A sole proprietor is treated as his or her own employer for retirement plan purposes.   For a self-employed person, compensation means “earned income.”    Earned income is net earnings from self-employment from a business in which your services materially helped to produce the income.  Net earnings from self-employment is your gross income from your trade or business minus allowable business deductions (including the deductible portion of your self-employment tax, shown on page 1, line 27 of your Form 1040).

Other Interesting Points:

  • A SEP-IRA cannot be a Roth IRA.
  • Employer contributions to a SEP-IRA will not affect the amount an individual can contribute to a Roth or traditional IRA.
  • Unlike regular contributions to a traditional IRA, contributions under a SEP can be made to participants over age 70 1/2.  If you are self-employed, you can also make contributions for yourself even if you are over 70 1/2.

Contribution Limits

For 2012, contributions cannot exceed the lesser of 25% of the employee’s compensation or $50,000.  Special rules apply when figuring the maximum deductible contribution for the “owner-employee.”  Let me illustrate with an example.

EXAMPLE:  You are a sole proprietor with no employees.  The terms of your plan provide that you contribute 25% (.25) of your compensation to your plan.  Your net profit from line 31, Schedule C is $40,000.  Your deductible self-employment tax (taken on page 1, line 27 of Form 1040) is $2,825.  Subtract this amount from the $40,000 to get net earnings from self-employment of $37,175.  Next, you multiply this amount by 20% (yes, 20%, not 25%, see Footnote below) to get $7,435.  This is your maximum deductible contribution.  You would enter this amount on Form 1040, page 1, line 28 as an adjustment (reduction) to your income.   Although this adjustment goes on page 1 of the Form 1040, it does reduce the Schedule C profit of $40,000 which also gets reported on page 1 of Form 1040.   Notice that the deductible portion of your self-employment tax ($2,825) and the SEP contribution ($7,435) have reduced your $40,000 Schedule C profit down to $29,740.  This amount gets further reduced by your personal and dependency exemptions and your standard or itemized deductions before you actually reach taxable income, the amount used to determine your income tax due. You will still be required to pay self-employment taxes on the $40,000 on Schedule SE (approximately $4,913 for 2012). [See my earlier post on “Writers and the Self-Employment Tax“].

I know, for many of you in the early stages of your career, that any profit is a solid achievement.  However, this is a worthwhile strategy for all to consider once profitability is attained.   As a self-employed person, it is up to you to put funds away for your future.  This is a great way to do it while lowering your current income tax bill.  The sooner you start, the longer your retirement funds will have to compound.

Your bank, credit union or broker will be happy (eager) to help you set up your SEP-IRA plan with forms that comply with the IRS requirements.  You will complete the paperwork (a few pages) and open your SEP-IRA at that institution and be on your way!


Helpful Resource:  Pages 22, 23 and 24 of IRS Publication 560 illustrate the deduction worksheet for those self-employed and also include a rate table conversion chart for the self-employed.

Footnote:  In order to arrive at a 25% contribution in the above example after the contribution is allowed as a deduction against your profit, it is necessary to do the following:  take the contribution percentage you want to use, such as 25% or .25, and divide it by 1.25, which then gives you the 20% figure to multiply the profit by before any SEP deduction.  In the above example, if you take the net earnings from self-employment, $37,175 and subtract the contribution of $7,435, you get $29,740.  Now, when you take that contribution of $7,435 and divide it by $29,740, you get 25%.  Therefore, you actually took a 25% contribution of your business profit after subtracting or allowing for the contribution.  As a self-employed person, this is your unique formula to arrive at the maximum deduction allowed.