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03/26/08 - The Best Retirement Vehicle for Self Employed Business Owners

By: Richard Feldman, CFP®, MBA, AIF®

The Individual 401K is hands down the best retirement vehicle available to self-employed individuals. For many years self-employed individuals wished for a better and easier way to save for retirement and they finally have a viable option. Business owners that employ only family members or part time non-family members now have the Individual 401K which allows them to put away a greater percentage of their gross income away for retirement.

The Individual 401K was born out of the Economic Growth and Tax Relief Reconciliation Act of 2001 and became available in 2002. Under the Individual 401K rules, sole owners of C or S Corporations as well as sole proprietors, can contribute $15,500 or 100% of their income, whichever is less, to the Individual 401k plan for the 2007 and 2008 tax years. If the owner is over age 50, he can also utilize the catch up provision and shelter an additional $5,000. In addition to the deferral and catch up provision, the business can make an additional employer contribution of 25% of the owner's compensation.

So how does this plan differ from traditional small business retirement plans?

Traditional small business plans such as a profit sharing plan, Keogh, or SEP-IRA allow annual deductible contributions equal to 25% of your compensation (if you're a corporation) or 20% of your self-employment income (if you're a sole proprietor) with a maximum of $46,000. The Individual 401K plan lets sole proprietors with net self-employment income of less than $230,000 (less than $184,000 for incorporated owners taking salary) to save a greater amount than they would otherwise be able to save with a traditional small business retirement plan.

This is possible thanks to the 2001 EGTRA rules which declared that an employee's pre-tax contribution (elective deferrals) no longer count towards the employer's deduction for making retirement plan contributions. Therefore, an owner acting as both employer and employee can make maximum contributions on both sides of the equation.

Let's look at two examples, one for a corporation and one for a sole proprietor.

Let's say your corporation pays you $50,000 in W-2 wages this year. The maximum deductible contribution to an Individual 401K would be $28,000 ($15,500 in employee deferrals + $12,500 in employer contributions). Using a Profit Sharing Plan instead would have only allowed you a tax-deductible contribution of $12,500 (25% of $50,000).

Now, say you are a Sole-Proprietor and you earn $50,000 from your business. The maximum deductible contribution to an Individual 401K would be $25,500 ($15,500 in employee deferrals +$10,000 in employer contributions). Using a Keogh or SEP-IRA would have only allowed you a tax-deductible contribution of $10,000 (20% of $50,000).

Other Individual 401K Advantages

Loan availability: Participants may borrow up to $50,000 or 50% of the value of the vested benefits in the plan, whichever is lower.

Contributions are not mandatory: Employer contributions are not mandatory every year. This allows small business owners to manage cash flows and contribute the maximum amounts in good years while contributing less or nothing at all should the business take a turn for the worse.

No 5500 filing: Businesses are not required to file Form 5500 with the Internal Revenue Service for plans that contain less than $200,000 worth of assets.

The Individual 401K tax-deductible contribution levels are particularly advantageous in the $50,000 to $100,000 range versus other retirement plans available to self-employed individuals.

Business Planning[1]

Looking at this from the perspective of a business owner, the Individual 401K makes a lot of sense for S Corporations. There has always been a tradeoff between higher retirement savings for owners and Social Security taxes. The more you have in W-2 income, the greater amount of Social Security taxes that are paid. With an owner-only plan and modest W-2 wages of $50,000, an S Corporation owner could contribute $28,000 ($15,500 employee deferral and employer contribution of 25% of $50,000). If the owner is over age 50 and able to utilize the catch up provision, the figure increases to $33,000. To contribute that much to a SEP in 2007, an S Corporation would have needed over $132,000 of W-2 income and incurred additional payroll taxes of $12,546.

A business owner who is the only employee of his own S Corporation would need compensation of $184,000 to make the maximum contribution of $46,000 (25% of $184,000), to a SEP or profit-sharing plan. This same contribution level could be achieved with only $122,000 of compensation utilizing the new Individual 401K ($15,500 employee deferral and $30,500 [25% of $122,000]).

The Individual 401K achieves the same contribution level with $62,000 less of compensation, which would cut payroll taxes by a considerable amount.

Family Planning

The effects of EGTRA 2001 provide a wealth of opportunities for self-employed individuals that have a spouse or child working in the business or for second income spouses. If your spouse has his/her own business and has $25,000 of net compensation, he/she can defer $15,500 into an Individual 401k plan and also contribute $5,000 as an employer contribution. This equates to 82% of net compensation being sheltered on a tax-deferred basis. The $20,500 in tax-deferred contributions would mean a savings of $7,175 of federal income taxes ($20,500 * 35%) assuming a couple is in the highest federal tax bracket.

The same math works for spouses or children who are employed in a family business. Say the spouse or child is employed in the business and receives $16,000 of compensation. They could defer $15,500 of the compensation as an employee contribution.

In conclusion, the Individual 401K provides the greatest leverage for self-employed business owners who are looking to save for retirement.

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[1] Mary L. Supovitz, Executive Vice President Pioneer Investments, Financial Advisor-December 2002

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