Many small-business clients run their operation as a one-person show. Once the business has turned the corner, the owner can focus on setting aside more funds for retirement. And the more he or she can save each year, the merrier the client will be.
Strategy: Point out the benefits of a solo 401(k) plan. As an employee, the client also can choose to defer part of his or her annual compensation to the plan. As an employer, the client can make contributions on behalf of employees – in this case, just himself or herself – within the generous tax law limits. In other words, the client gets the best of both worlds.
This double-barreled tax action can’t be beat. With a solo 401(k) plan, a small-business owner can sock away more money than just about any other retirement plan on the block.
Background information: With the usual defined contribution plan chosen by small-business owners – such as a Simplified Employee Pension (SEP) – the employer’s deductible contribution for 2010 is capped at the lesser of 25 percent of compensation or $49,000 ($54,500 if you’re age 50 or older). Note: The maximum compensation that may be taken into account for these purposes is $245,000 for 2010. (These figures are adjusted annually for inflation.) But that’s as far as it goes.
In contrast, an employee participating in a traditional 401(k) plan can make an elective deferral to the plan within annual limits, and the employer may match part of your contribution. Usually, it will add an amount equal to a single-digit percentage of the employee’s compensation.
Now see what happens when a business client goes solo. For 2010, the client can defer up to $16,500 of compensation to his or her 401(k) account, plus an extra catch-up contribution of $5,500 is allowed if the client is age 50 or older – the same as with elective deferrals to a traditional 401(k). Of course, the limits on deductible employer contributions still apply, but here’s the kicker: Thanks to a recent tax-law change, elective deferrals to a solo 401(k) don’t count toward the 25 percent cap. So the client can combine an employer contribution with an employee deferral for even greater savings.
Example: Big tax savings for small-business owner
Let’s say that Milton Greenbaum, age 45, and his one-man company pays him $125,000 in wages. The maximum deductible amount Milton could contribute to a SEP in 2010 is $31,250 (the lesser of 25 percent of compensation, or $49,000). If he sets up a solo 401(k) plan instead, he can defer $16,500 to the account in addition to keeping the maximum $31,250 employer contribution. That gives Milton a total contribution of $47,750 (below the $49,000 limit). And, since he is the only employee of the company, Milton doesn’t have to worry about making contributions for anybody else.
The contributions to a solo 401(k) grow tax-deferred until Milton is ready to make withdrawals. For simplicity, suppose he contributes $47,750 to his account each year for the next 20 years until he retires. If Milton earns 8 percent a year, he will have accumulated a whopping nest egg worth $2,359,944!
Conversely, if he contributes just $31,250 to a SEP for 20 years, instead, and invests it at the same 8 percent rate, Milton will accumulate $1,544,466 before retirement – or $815,478 less.
If the business isn’t incorporated, the 25 percent-of-compensation cap on employer contributions is reduced to 20 percent because of the way contributions are calculated for self-employed individuals. But that still leaves a client with plenty of room to maneuver. For instance, if a client’s net self-employment income is $125,000, he or she can stash away up to $41,500 ($16,500 deferral and $25,000 employer contribution) in the account this year. And remember that contributions can be boosted once the business owner reaches age 50.
Note that a solo 401(k) may offer other advantages. For instance, the plan can be set up to allow loans and hardship withdrawals. Also, a business client can roll over funds tax-free from another qualified plan from a place where he or she used to work.
Advisory: Contributions are discretionary. Therefore, a client can cut back on the annual contribution – or skip it entirely – if the business has a bad year.
Are there any drawbacks?
Do solo 401(k) plans sound too good to be true? They’re not, but there are two key considerations.
- If the business has any other employees, they must be covered under the plan.
- The owner must deal with the paperwork and cost of running the plan.
Good news: After the tax rules changed to favor solo 401(k) plans, more of the bigger players got in the game. Now that financial outfits such as Smith Barney and Fidelity offer solo 401(k) programs, the administrative costs have gone way down. Typically, a small-business owner might be charged a one-time setup fee of $100 and a small annual administrative fee ranging from $50 to $250.
Limits on 401(k) advice
The ground-breaking Employee Retirement Income Security Act (ERISA) prohibited 401(k) plans from offering investment advice to participants. In effect, participants were left to fend for themselves.
Update: Under the Pension Protection Act, ERISA-covered plans can offer participants advice through a registered investment company, registered broker dealer, bank, or insurance company acting as a fiduciary.
To protect 401(k) plan participants, charges paid for those services must be based on an independent third-party certified computer model. The fees can’t vary based on recommendations or investment products.
Reprinted with permission from The Tax Strategist, June 2010. For continuing advice on this and numerous other tax strategies, go to www.TaxStrategist.net. Receive 2 FREE Bonus reports and a 40% discount on The Tax Strategist when you use Promo Code WN0013.