A 401k retirement plan for the self-employed

If you earn income in any of the following ways, you may file your tax return as a self-employed sole proprietor (SESP):

• Independent contractor
• Manager of a small, unincorporated business
• Provider of medical, legal, or other professional services
• Consultant or freelancer in your area of expertise
• Provider of home, household, or construction services
• Head of a home-based retail operation
• Hobbyist who sells his or her work

Even if you are employed by another company, you can qualify as an SESP if you are also earning a second income from a sideline business. SESPs report their income on Schedule C, Profit or Loss from Business, along with Form 1040. Filing in this way allows you to establish a retirement plan for your business that will provide you with significant current and future benefits.

This article focuses on unincorporated sole proprietors who use Schedule C and have no employees (other than a spouse). It looks at the Individual 401k, which is also known by several other names: Solo 401k; Employer-Only 401k; Mini 401k; Single Participant 401k; and Uni-K. The key factor is that the SESP (plus a spouse) is the only participant in the plan, which is relatively simple, flexible and easy to implement. The plan entails minimum administration and has generous contribution limits in comparison with other plans.

The popularity of this plan increased dramatically as a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which changed the formula for calculating maximum contributions and allowed larger deductible contributions than were permitted under prior laws. Although the provisions were scheduled to expire in 2010, Congress made them permanent last summer by passing the Pension Protection Act of 2006. SESPs who delayed establishing a Solo 401k can now do so without concern that the limits will revert to older, lower amounts or that favorable provisions will expire.

In a larger company situation, tax advantaged retirement plans like 401k's give tax breaks to both employers and employees. Employers can deduct their contributions to retirement plans from their federal income tax returns. Employees can make contributions that reduce their pretax salaries, and get tax deferred growth on investments. An SESP gets to participate in an Individual 401k plan as both employer and employee -- and benefit from both roles.

Provisions of an Individual 401k plan

An Individual 401k plan is a regular, pre-tax, salary deferral 401k plan combined with a profit- sharing plan. It can be implemented only by self-employed individuals who have no employees -- except a spouse. The employee salary deferral contribution is the same as for a regular 401k: a maximum of $15,500 in 2007 with a catch-up contribution of $5,000 for those over age 50 in 2007 for a total of $20,500.

The business can make a profit-sharing contribution to an Individual 401k plan of up to 20 percent of net business income from Schedule C, minus half the self-employment tax of 15.3 percent (i.e., 7.65 percent, as shown in example below). The maximum amount allowable for net business income is $225,000 for 2007. All contributions by the business are 100 percent vested immediately.

Total contributions in 2007, including both employee and employer portions, cannot exceed $45,000 for participants under age 50. Those over age 50 can add a $5,000 catch-up contribution, bringing the maximum to $50,000.

Let's look at an example. Ron, age 51, is an unincorporated, self-employed electrician claiming $80,000 of net business income on Schedule C. The following table shows the effect of his maximum contributions to an Individual 401k plan.

Ron and his business can make a contribution of up to $34,776. This comprises a $20,500 employee contribution (including catch-up) and a $14,776 employer contribution (20 percent of net business profit less half the employment tax: $80,000 - $6,120 = $73,880 x .20 = $14,776).

Advantages of an Individual 401k plan

The Individual 401k has some of the same advantages as other plans but some unique ones as well.

• In most cases the allowable contribution is larger than it would be under another type of retirement plan.
• It is easier to administer because it is not subject to complicated discrimination testing rules required for regular 401k plans or other qualified retirement plans.
• As with other 401k plans, contributions by the employee are income tax-free, and the business contributions are tax-deductible. There is tax-deferred growth on investment earnings.
• Contributions are completely discretionary. You can reduce or suspend contributions on either the business or employee side without penalty in years when revenue is lower.
• Loans and hardship withdrawals can be allowed. Loans are not subject to penalties but must be repaid. Failure to repay will create income taxes and penalties. Hardship withdrawals are subject to income tax but the 10% penalty only applies if the individual is under 59½.
• Rollovers from other retirement savingsm such as an IRA or another employer's 401K plan, are allowable.

Disadvantages of Individual 401k plans

Although the advantages certainly outweigh the disadvantages, the Individual 401k has some drawbacks.

• You must pay to establish the plan, which requires a written document describing the plan and how it works. Most institutions providing these plans have prototype documents for this purpose and may charge a set-up fee in the range of a few hundred dollars.
• The annual paperwork reporting requirement begins and remains when assets in the plan exceed $100,000. Small businesses can use IRS form 5500EZ to meet this requirement.
• Institutions offering these plans may have limited investment choices. This may change as the demand for these plans increases, now that the 2001 provisions are permanent. Also, more institutions may decide to become providers.
• An Individual 401k plan may not meet the needs of the business as it grows and hires additional full-time employees. If these employees are eligible to participate in a retirement plan, they must be included, so the individual plan would no longer apply.
• A trustee is needed to hold the assets on your behalf. Some self-employed people act as their own trustees, but this requires time-consuming recordkeeping.
• If you have a dual income (i.e., you are also earning money as a salaried employee), then your contributions to your employer's 401k plan must be counted toward your maximum employee contribution limit of $15,500 ($20,500 for 50+) for the individual plan.

Overall, the current tax benefits and future retirement income provided by an Individual 401k plan justify serious consideration as a retirement savings vehicle. The signing of the Pension Protection Act of 2006 solidifies its position in retirement planning and makes it all the more attractive for SESPs.

NOTE: The information provided in this article is meant to enhance the understanding of retirement planning. It does not suggest or constitute tax, financial, or legal advice. Consult your financial advisor for specific advice about your own circumstances.

Related links

Schwab individual 401k

Retirement audit: Uni-k plans

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