GOING SOLO WITH A 401(K)

The self-employed and small-business owners with no full-time employees except a spouse have a potentially better retirement plan available starting in 2002: the 401(k).

Yes, individual 401(k) plans have long been available, but they were too expensive compared with other options such as the SEP (simplified employee pension plan) and the Keogh plan. But the 2001 Tax Relief Act changed all that. Whether incorporated or unincorporated, the self-employed who can afford to sock away upwards of $40,000 a year in retirement will want to take a close look at the solo 401(k).

The Tax Relief Act made two major changes that make individual 401(k) plans practical. First, effective starting in 2002, incorporated employers of solo businesses can now contribute tax-deferred to the plan up to 25 percent of an employee’s pay instead of only 15 percent (the percentage is effectively less than 25 percent for the unincorporated because of a self-employment tax adjustment). More important, the employee’s contribution, which is a maximum of $11,000 in 2002  (rising to $15,000 by 2006), or 100 percent of pay, is no longer is counted as part of the employer’s 25 percent contribution limit. 

The combination of these contributions cannot exceed $40,000 or 100 percent of compensation. In addition, for 2002, an employee age 50 and over can kick in another $1,000 a year (rising to $5,000 extra by 2006)—a grand total of $41,000! That’s significantly more, under most circumstances, than the maximum of popular alternatives such as SEPs and Keoghs for the same level of income.

Take an incorporated business owner earning $80,000. First, the owner can set aside 25 percent of pay as an employer—in this case, $20,000. In addition, the “employee” contribution can go up to $11,000, plus another $1,000 if the owner if age 50 or over. That’s a grand total of $32,000! For an unincorporated business, the total would be $26,870.[Solomon Smith Barney, hard copy file] [Slott newsletter, 7]

Of course, you don’t have to contribute the maximum amount, or any amount for that matter, in any given year, which makes it attractive compared with some alternatives that require annual contributions.

In addition, unlike other self-employed plans, the participant can borrow from the plan, up to $50,000, free of taxes and penalties. The ability to borrow can be especially attractive to cash-strapped business owners, though it’s always better to avoid borrowing from your retirement plan if possible. You’re slowing the growth of your nest egg and you’ll have to pay regular income taxes and possibly a ten-percent penalty on any amount you fail to pay back.

In addition, you can roll over assets into the individual 401(k) from some other retirement plans, such as a former employer’s 401(k) or a Keogh, and the assets may be protected from creditor claims.

Despite the new attractiveness of individual 401(k) plans, they’re not for everyone who’s eligible.

To begin with, owner-only 401(k) plans—like their multi-employee brethren—generally have been more expensive to set up and administer than traditional alternative plans. Consequently, unless you’re able to afford to contribute significantly more than the maximum under alternatives, you may be better off sticking with them instead of a solo 401(k). The exceptions might be those whose household has another major source of income or perhaps older owners without children and mortgage payments and who are able to sock away maximum amounts before retirement.

Some traditional plans also become competitive again from a contribution and cost standpoint for owners earning $160,000 or more. That’s the income amount at which an incorporated business can sock away $40,000 in a SEP-IRA or profit-sharing plans (an unincorporated business earning $200,000 can contribute up to $38,412).

On the other hand, costs for many solo 401(k)s have come down significantly, and are expected to decline further, and some plans are already very competitive with alternatives.

Another current drawback is that many solo 401(k) plans don’t offer as many investment choices as their competition, though that too is changing as they expand their investment options.

Business owners can hire their spouse or have partners without affecting an individual 401(k) plan. But if they plan on hiring full-time employees age 21 or over or part-time employees working more than 1,000 hours, they may want to shun the solo 401(k). That’s because the employees must be offered participation in the plan, which will likely restrict the owner’s personal contributions and require additional record keeping.

October 2002— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by McGuire & Co., LLP, a local member in good standing of the FPA.