Entrepreneurs succeed by taking advantage of business opportunities, and retirement savings options are no different. For the self-employed and small business owners with no employees, recent tax law changes make the one-person 401(k) a very attractive opportunity.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)* increased the contribution limits for one-person 401(k) plans, allowing self-employed workers to save more for retirement. This may make the one-person 401(k) more useful to high-income self-employed individuals than more traditional offerings such as Simplified Employee Pension (SEP) plans and Savings Incentive Match Plans for Employees (SIMPLEs).
Before EGTRRA, participants were allowed only a 15% profit-sharing deduction and could not also make elective deferrals. Now, if you have a one-person 401(k), you may be eligible to make elective salary deferrals and take a business deduction for profit-sharing contributions. Contributions to such a plan reduce your taxable income. A small business owner with no employees can deduct up to 25% of his or her salary with up to $220,000 (subject to inflation indexing) of compensation eligible for consideration, and may elect to defer a portion of his or her salary up to specified limits ($15,000 in 2006). The combination of your profit-sharing and salary-deferred contributions to your 401(k) may not exceed $44,000 in 2006 (subject to inflation indexing). However, those aged 50 and older are allowed to make additional "catch-up" contributions of up to $5,000.
The following hypothetical illustrates the greater contributions possible with a one-person 401(k):
45-year-old self-employed consultant Lisa Anderson has an adjusted earned income of $100,000. Because she owns her own corporation and has no employees, she takes a profit-sharing deduction for her contributions to a one-person 401(k) for 25% of her eligible compensation, totaling $25,000. Lisa also elects to defer $13,000 of her salary to her 401(k), bringing the total of her contributions to $38,000 -- significantly more than she could save with a SIMPLE, which had an elective deferral limit of $10,000 in 2006.
One-person 401(k) plans have other benefits: because there are no other employees, you avoid nondiscrimination testing, and the plans themselves are relatively simple and inexpensive. If you currently have another 401(k) plan, you may be able to roll it over into a one-person 401(k). Earnings in these plans grow on a tax-deferred basis, and you may be able to take out loans subject to the limitations of your plan. (Bear in mind that withdrawals made before the age of 59½ may be subject to a 10% federal income tax penalty.)
The current tax situation makes the one-person 401(k) an unprecedented opportunity for today's entrepreneur to prepare for retirement. Why not start today?
*According to the Economic Growth and Tax Relief Reconciliation Act of 2001, these favorable retirement incentives were originally set to expire in 2011. However, these provisions were made permanent in the Pension Protection Act signed into law on August 17, 2006.