If you are self-employed or own a small business, you have probably considered establishing a retirement plan. If you have done your homework, you likely know about simplified employee pensions (SEPs) and savings incentive match plans for employees (SIMPLE) IRA plans. These plans typically appeal to small business owners because they are relatively straightforward and inexpensive to administer. What you may not know is that in many cases an individual 401(k) plan (which is also known by other names such as a solo 401(k) plan, an employer-only 401(k) plan, or a single participant 401(k) plan) may offer a better combination of benefits.
What is an individual 401(k) plan?
An individual 401(k) plan is a regular 401(k) plan combined with a profit-sharing plan component. However, unlike a regular 401(k) plan, an individual 401(k) plan can be implemented only by self-employed individuals or small business owners who have no other full-time employees (an exception applies if your full-time employee is your spouse). If you have or will be hiring full-time employees age 21 or older (other than your spouse) or part-time employees who work either 1,000 hours a year for one year or 500 hours a year for three consecutive years, you will typically have to include them in any plan you set up; in this case, adopting an individual 401(k) plan will not be a viable option.
What makes an individual 401(k) plan attractive?
An individual 401(k) plan may be an attractive retirement savings vehicle because in most cases your allowable contribution will be as large as, or larger than, you could make under most other types of retirement plans.
With an individual 401(k) plan you can elect to defer up to $20,500 of your compensation to the plan for 2022 (plus catch-up contributions of up to $6,500 if you’re age 50 or older), just as you can with a regular 401(k) plan. In addition, as with a traditional profit-sharing plan, your business can make a maximum tax-deductible contribution to the plan of up to 25% of your compensation* (up to $305,000 of compensation in 2022).
Because your 401(k) elective deferrals do not count toward the 25% limit, you, as an owner-employee, can defer the maximum amount of compensation under the 401(k) plan, and still contribute up to 25% of total compensation to the profit-sharing plan on your own behalf. Total plan contributions for 2022 cannot exceed the lesser of $61,000 ($67,500 if you include catch-up contributions) or 100% of your compensation.
Let’s look at an example: Dave is 35 years old and the sole owner of an incorporated business with no other employees. His W-2 compensation in 2022 is $100,000. Dave sets up an individual 401(k) plan for his retirement. Under current tax law, Dave’s plan can accept a tax-deductible profit-sharing contribution of $25,000 (25% of $100,000) from the business, plus a dollar-for-dollar 401(k) elective deferral of $20,500. As a result, total plan contributions on Dave’s behalf can reach $45,500. This is a meaningful contribution difference when comparing Dave’s scenario using a SEP IRA plan or SIMPLE IRA plan which would result in maximum contributions of $25,000 or $17,500, respectively. The outcome is higher tax savings with an individual 401(k).
The individual 401(k) contribution possibilities are not unique to individual 401(k) plans; any business establishing a regular 401(k) plan and a profit-sharing plan could make similar contributions. However, individual 401(k) plans are simpler and less expensive to administer than a regular 401(k). Since they cover only a self-employed individual or business owner and his or her spouse, individual 401(k) plans are not subject to the often burdensome, complicated, and costly administrative rules nor the discrimination testing and record-keeping systems that are generally required for regular 401(k) and profit-sharing plans.
Potential drawbacks of an individual 401(k) plan include the need to file an IRS Form 5500 tax return when the plan investment balance reaches $250,000, and whether or not plan assets will be protected from your creditors (outside of bankruptcy declarations).
Other advantages of an individual 401(k) plan:
- The plan is a tax-deferred retirement plan, so you pay no income tax on plan contributions or earnings until you withdraw money from the plan, generally in retirement. And your business’s contribution to the plan is tax deductible.
- Contributions to a plan are completely discretionary, both your elective deferral and the business profit-sharing contributions. You should always try to contribute as much as possible, but you have the option of reducing or even suspending plan contributions if necessary.
- A plan can allow loans and may allow hardship withdrawals if necessary.
- A plan can accept rollovers of funds from another retirement savings vehicle, such as an IRA, a SEP plan, or a previous employer’s 401(k) plan.
If you are a small business owner with no employees (other than your spouse) an individual 401(k) plan with profit-sharing can accomplish both significant tax savings and annual retirement contributions for minimal costs and simplified administration. As you approach the last quarter of another tax year, there is no better time to consult a fiduciary advisor to help with your retirement savings plan options.
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