Owner-Only Businesses Should Consider a Solo 401(k) Plan
Article Highlights
- Solo 401(k) plans allow greater income deferral than most other retirement plans.
- A Solo 401(k) plan suits self-employed and owner-only corporations.
- The plan needs to be established prior to year's end.
- The plan is generally not beneficial if company has employees other than a spouse.
Generally, Solo 401(k) plans are a natural fit for two categories of people. The first are those who operate a business as an independent contractor, sole proprietor, or owner-only C or S corporation. The second are those who have dual incomes: they are W-2 wage earners as employees of a company that offers a 401(k) plan, but also have consulting income from corporate directorships or freelance work that requires them to file a Schedule C as a sole proprietor. Since the 401(k) contribution limits apply to each individual for the year and not to the individual plans, the taxpayer who has multiple 401(k) plans needs to make sure that no more than the annual limit is contributed to the total combination of plans.
For 2013, the rules limit employer contribution (profit-sharing contribution) to 25% of compensation. The employee can also make salary deferral contributions up to $17,500. Together, these contributions cannot exceed the lesser of $51,000 or 100% of compensation. In addition, if the employee is aged 50 or over, he or she can make an additional catch-up contribution of $5,500. The business owner in these arrangements is considered to be both an employee and an employer.
Example: Susan Lewis, 49, is the sole employee of an incorporated business. Her earned income is $100,000 in 2013. Under the law, Susan can contribute $25,000 to a SEP-IRA ($100,000 × .25), $14,500 ($11,500 plus 3% of $100,000) to a Simple IRA, or $25,000 to a profit-sharing or money purchase plan. On the other hand, she can contribute $42,500 to a Solo 401(k) plan ($25,000 employer contribution plus $17,500 employee deferral), which is still under the $51,000 maximum for the year. If Susan is 50 or over, she can also make a catch-up contribution of $5,500, increasing her 401(k) contribution total to $48,000.
In some cases, 401(k) plan contributions for an unincorporated business may be slightly lower than the above amounts. For unincorporated businesses, compensation is net profit minus half of self-employment taxes minus employer contributions.
Although single-participant 401(k) plans are limited to the business owner and his or her spouse, business owners should note the added benefits of having his or her spouse as the business's only other employee. Having the spouse on the payroll allows the business owner to shelter some or all of his or her income by having his or her spouse make an elective deferral to a 401(k) plan in addition to the business making a profit-sharing contribution. Although the spouse and the business would be responsible for their respective shares of employment taxes on the salary, combined employer and employee contributions could be up to the lesser of $51,000 (for 2013) or 100% of compensation. This limit applies separately to the business-owner and the spouse, thus allowing a combined total of up to $102,000 (for 2013). In addition, if aged 50 or over, each individual could defer an additional $5,500 each year.
Potential downside: If a business grows and begins to hire employees, the single-participant 401(k) plan must become a full-blown 401(k) plan subject to other, more stringent rules, including discrimination testing, that can serve to limit contributions by highly paid executives. Many providers recommend that businesses with immediate expansion plans not set up one of the Solo 401(k) arrangements.
Caution: If the business owner has other businesses or is part of a controlled group of corporations, partnerships, proprietorships, or affiliated service groups, the employer aggregation rules may apply and the employees of those other businesses may have to be considered for purposes of meeting qualification and minimum coverage requirements for the Solo 401(k).
For additional information about Solo 401(k) plans and how they might fit into your tax strategy and retirement-planning, please give this office a call. If you are considering a Solo 401(k) plan, be aware that the plan must be set up before year's end.
|  |