Professional Services Accounting ARTICLE -
Is There a "New 401(k) Plan?"

Target Audience: Law Firm Professionals, Lawyers, Contribution Plans Interest

Some clients specifically may have asked about the "new type of 401(k) plan" or what has been referred to as the "Solo 401(k)." It is not really a new plan created under the Code or by recent legislation, it is a product of clever marketing by brokers, banks, insurance companies, and some practitioners who are trying to "sell" the idea of a 401(k) plan to sole proprietors or sole owners of corporations who do not have employees. These Solo 401(k) plans are not just a sales gimmick. They are popular because they are providing a way for sole proprietors and sole owners of corporations who do not have employees to save much more for retirement than the other retirement plan options available for the self-employed.

These business owners were more apt to choose a company pay-all profit-sharing plan, a SEP or SIMPLE plan than a 401(k) plan in the recent past. The seemingly sudden appearance of the Solo 401(k) occurred largely because of changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Tax Act). The advantages of a Solo 401(k) have significantly increased due to these changes. The changes allow a Solo 401(k) plan to be established to maximize contributions made by sole proprietors or sole owners without the additional costs traditionally associated with 401(k) plans maintained for a group of rank and file employees. In addition, since Solo 401(k)s are obviously free from the requirement to perform nondiscrimination testing that normally applies to 401(k) plans, these plans can be drafted and administered much more simply and in a more cost effective manner.

TIP: Solo 401(k)s can be extended to cover the business owner's spouse with the same results. A Solo 401(k) can also be converted to a Mini-401(k) to cover the business owners' immediate family members permitting several family members to obtain the advantages available through a Solo 401(k).

Changes Made by 2001 Tax Act

Three important changes were made by the 2001 Tax Act that combine to make the Solo 401(k) something that sole owners and sole proprietors should reconsider. These changes are:

1. The increase in the maximum allowable annual elective deferral limit;
2. The increase in the Code Section 415 limit - the maximum annual amount that can be contributed to the plan by the employee and employer collectively; and
3. The increase in the maximum deductible contribution limit along with a change in the way the deductible limit is determined.

Increase in Annual Elective Deferrals

Before the 2001 Tax Act the maximum that an employee could elect to defer on a before tax basis under a 401(k) plan was based on a $7,000 base amount, which through cost-of-living adjustments had risen to $10,500 in 2001. The 2001 Act started making increases in this amount in 2002 and for 2004 the amount is $13,000. This amount is going to increase in $1,000 increments in 2005 and 2006, ending up with a $15,000 limit in 2006, which will be increased annually from there based on cost-of-living in $500 increments.

This maximum deferral limit may be further increased by catch-up contributions. If the business owner has attained the age of 50 by the end of the calendar year, he can make additional catch-up contributions. For 2004, the catch-up amount is $3,000, and it increases in $1,000 increments in 2005 and 2006, ending with $5,000 in catch-up contributions allowable for 2006 and thereafter.

TIP: Catch-up contributions can be made over and above the limits on employee and employer contributions under Code Section 415(c).

Changes In the Code Section 415(c) Limit

The Code Section 415(c) limit which provides an overall maximum for the annual contributions that can be made by the employer and the employee was changed effective for plan years beginning in 2002 to the lesser of 100 percent of compensation or $40,000 (which for 2004 has increased to $41,000). The 2001 Act had increased this limit from the lesser of 25 percent of compensation or $35,000.

OBSERVATION: The increase in the percentage limit from 25 percent to 100 percent has a significant potential impact on the establishment of Solo 401(k)s, especially when that employee is paid a modest salary (such as $40,000 or under). This impact occurs because the employee can receive a total aggregate contribution, taking into account both his salary deferral contribution and the employer contribution of up to 100 percent of before-tax compensation before exceeding the 415 limit.

Changes to The Employer's Deductible Limit

Before the 2001 Act, the maximum deductible contribution that a company could make to a profit-sharing plan was limited to 15 percent of compensation. The 2001 Act increased this deductible limit to 25 percent of compensation. Code Section 401(k)(2) provides that all 401(k) plans must be part of an underlying profit-sharing, stock bonus, rural cooperative, or pre-ERISA money purchase pension plan. Since, the vast majority of 401(k) plans existing today are part of an underlying profit-sharing plan, the maximum deductible limit for such contributions has also increased to 25 percent of participant of participant compensation.

In addition to increasing the maximum deductible limit, the 2001 Act made another change to the deductible limit that has even greater significance for 401(k) plans. Under Code Section 404(n), elective deferrals no longer count toward this 25 percent deductible limit. This means that an employer is free to make a contribution of the full 25 percent of employee compensation, without regard to the level of elective deferrals made by the employee.

Running the Numbers

For business owners that are looking for the maximum amount to contribute to a deductible account, the Solo 401(k) cannot be beat. The reason for this: annual contributions consist of two parts - (1) 100 percent of the maximum elective deferrals (for 2004, $13,000; $16,000 for those over 50) and (2) 25 percent of employee compensation for a corporate business owner and 20 percent of self-employment income for a sole proprietor.

EXAMPLE 1: For 2004, Sam Smith, age 51, who is the sole shareholder and sole employee of Sam Smith, Inc., is paid a salary of $80,000. The maximum deductible contribution that can be made to Sam Smith Inc. 401(k) plan on behalf of Sam Smith is $36,000 calculated as follows: $13,000 maximum elective deferral contribution + $3,000 maximum catch-up contribution + .25 x $80,000 = $36,000

EXAMPLE 2: For 2004, assuming the same facts as Example 1, with the exception being that Sam Smith is the sole employee of his sole proprietorship, Sam Smith Company, the maximum deductible contribution is $32,000 calculated as follows: $13,000 + $3,000 maximum catch-up contribution + .20 x $85,000 = $32,000.

EXAMPLE 3: In both Examples 1 and 2, if Sam Smith had been age 49, the maximum contributions would be $33,000 and $29,000 respectively (calculated by subtracting the allowable $3,000 catch-up contribution).

Before the 2001 Act, sole owners of businesses did not set up Solo 401(k)s because they could get the same deduction by establishing an employer pay all profit-sharing plan. For purposes of comparison, if Sam Smith, Inc. established an employer pay all profit-sharing plan at this time, the maximum deductible contribution that could be made to the plan for 2004 would be $20,000 - a significant difference from the $36,000 discussed above in the case of a Solo 401(k).

If the examples above had the business owner making a salary or net self-employment income of greater than $80,000, an even larger contribution may be made to the Solo 401(k). However, regardless of the salary or self-employment income, the maximum contribution that can be made for 2004 is $41,000 (or $44,000 for those who attain age 50 by the end of 2004).

It also important to note that the maximum contribution amounts will increase in 2005 and 2006 and beyond partially due to the increase in the maximum elective deferrals that will be permitted in those years and partially due to cost-of-living increases on the Code Section 415(c) overall limit on employee and employer contributions.

2004 Numbers for SEPs and SIMPLEs

The maximum contribution that a sole owner of a business or a sole proprietor can make to a SEP for 2004 is the lesser of 25 percent of compensation or $41,000.

TIP: If the business owner established the SEP in 2004, then no salary deferral amount can be contributed to the SEP. If the business owner established a salary reduction SEP (referred to as a SARSEP) before 1997, then in 2004, up to $13,000 can be contributed through salary reduction contributions to the SEP. In addition, the employer is permitted, but not required to allow catch-up contributions to a SARSEP in 2004 of up $3,000.

The maximum salary reduction contribution that can be made to a SIMPLE for 2004 is $9,000. The employer can, but is not required to permit catch-up contributions to the SIMPLE up to a maximum of $1,500 for 2004. In addition, the employer is required to make a matching contribution based on the amount of each employee's salary reduction contribution, generally not to exceed 3 percent of compensation.

Based on the contribution limits for SEPs and SIMPLEs for 2004, the sole owner of a business or a sole proprietor can shelter more money from taxes with a Solo 401(k) plan than with either or these plans.

Other Advantages of Solo 401(k)

One of biggest advantages of a Solo 401(k) is the ability for the business owner to obtain a loan from the plan. There are certain formalities that must be followed in order to obtain a loan. However, this is the only type of retirement plan available to self-employed individuals that provides this opportunity. Generally, the maximum amount that the Solo 401(k) participant can borrow from his plan is $50,000.

Another advantage is the flexibility inherent in a Solo 401(k). The business owner will not be stuck with making any fixed amount of contributions to plan. The business owner can choose the amount of contributions to make each year up to the maximum allowable or he can choose not to make a contribution at all in any given year.

Disadvantages of Solo 401(k)

The principal disadvantage of the Solo 401(k) becomes apparent if the business owner decides to hire employees other than immediate family members. When that happens, with certain exceptions, the employer would have to make a contribution on behalf of each additional employee. A business owner will be able to determine when he begins to hire staff, whether to convert the Solo 401(k) to a regular company-wide 401(k) at that time. If he does not want to expand it to cover employees, the plan will have to be terminated before employees are hired.

A second disadvantage is that the Solo 401(k) is a tax-qualified retirement plan and as such it must keep up with all of the changes in the law that affect retirement plans qualified under Code Section 401(a). The business owner can minimize the costs of keeping the plan qualified by adopting a prototype plan from a bank, insurance company, brokerage firm, or other financial institution that sponsors 401(k) plans.

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