The following is a discussion of the merits of the Individual 401k plan as a retirement savings alternative for self-employed individuals such as independent contractors, sole proprietors, and single employee C and S corporations. The sources for this discussion are materials that originally appeared in the Journal of Accountancy in 2003, as well as material from the IRS Website (IRS Retirement Plans Navigator), IRS Publication 560 and Charles Schwab.
Background:
Beginning with the Economic Growth and Tax Reconciliation Act of 2001 (EGTRA), self employed individuals obtained a strong incentive to establish individual 401k plans as opposed to the more common SEP IRA. The SEP IRAs had been the vehicle of choice prior to EGTRA because they are easy to set up, and because employers had been required to deduct employee salary deferrals from the maximum tax-deductible retirment plan contribution (1). After EGTRA the advantage shifted to the Individual 401k. Employers were no longer required to deduct the Employee salary deferral from their calculation of the maximum retirement plan contribution. Hence, self employed individuals were entitled to take their maximum salary deferal and have their business make its maximum annual contribution to their retirement plan.
Quantifying the Advantage of the Individual 401k:
Let's put some numbers on this. For 2009/10 the maximum annual employee contribution to a 401k is $16,500. Employees above the age of 50 may be eligible to make a catch up contribution of $5500. The maximum total contribution from Employer and the Employee is 20% of eligible compensation or $49,000 (or $55,000 if over 50). Self employed individuals can contribute this amount to their Individual 401k plans.
Self employed individuals using a SEP IRA in 2009 are entitled to contribute the lesser of $49,000 or 20% of eligible compensation.
For 2009, $245,000 is the maximum allowable compensation that may be used to calculate the amount of benefits. This applies to both Individual 401k and SEP IRA. It is only at this $245,000 level that the SEP IRA provides an equal maximum contribution to the Individual 401k. For all lower levels, the Individual 401k allows a greater maximum contribution (2).
Individual 401k vs. SEP IRA Breakeven Analysis
Individual 401k Candidates (3)
An individual 401k is designed for self-employed individuals, and owner-only businesses with no employees, other than a spouse (includes corporations, partnerships and sole proprietorships).
Target profile
1. Wants to make larger contributions than are typically allowed by SEP IRA or QRP.
2. Needs flexibility on annual contributions
3. Wants an easy to administer, low-cost plan
Eligibility
1. Must have no employees other than a spouse
2. A partnership is eligible only if each partner owns 5% of the business
3. A corporation is eligible only if it has no employees other than a sole shareholder and his or her spouse
Disclaimer: This report was produced by South Shore Capital Advisors LLC for information purposes only. It is not intended that this serve as tax advice. Individuals should consult with their tax advisors prior to making any tax-related decisions regarding their retirement savings. South Shore Capital Advisors is a Massachusetts and Rhode Island Registered Investment Advisor.
(1) “The Single Participant 401K”, Journal of Accountancy, March 2003.
(2) IRS Publication 560 p. 1, p. 24.
(3) Charles Schwab
Copyright 2009, South Shore Capital Advisors, LLC, 16 North Street Hingham, MA 02043
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