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