Solo 401ks
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SOLO 401ks
First allowed in 2002, so-called "Solo 401k plans" or "Individual(k) plans" emerged as a plan that help many small business owners shelter a significantly greater portion of their income for retirement than they were previously eligible to shelter through profit sharing plans, money purchase pension plans, simplified employee pension (SEP) plans and savings incentive match plans for employees (SIMPLEs).
The new Solo 401k plan is a type of 401k plan. However, it's an entirely different breed from the conventional 401k plan typically sponsored by companies with multiple employees. The Solo 401k plan is - by design - made to fit owner-only businesses and businesses with employees that can be excluded under federal laws governing plan coverage requirements -- such as part-time employees, non-resident aliens or union employees covered by collective bargaining agreements. "Owner-only" refers to the owner(s) and immediate family members, such as a spouse and children. Because the Solo 401k plan is designed for owner-only coverage, when compared to conventional 401k plans, the Solo 401k plan is less complex, less burdensome to administer, and less costly to maintain. They can, however, offer all the benefits of a 401k, including loan provisions and hardship distributions.
Prior to tax code revisions in 2001, there was no practical reason to use a 401k plan for an owner-only business. However, as of 2002, there are some very compelling reasons for certain small business owners to consider Solo 401k plans, principallly, to maximize retirement savings.
To summarize the contribution limits for 401k plans:
the maximum total contribution to 401k plans is the lesser of 100% of employee compensation or $40,000 adjusted for inflation ($45,000 in 2007), the deduction limit for the employer is 25% of payroll payable to all eligible employees. In a practical sense for an owner-only business, 25% is the maximum permissible limit for employer contributions,the annual elective deferral limit is 15,500 in 2007, adjusted for inflation, plus catch-up contributions for those age 50 and up ($5,000 in 2007).As a result, the maximum amounts that can be contributed to a Solo 401k plan for the business owner are 25% of compensation from the "employer" as a profit-sharing contribution plus the "employee's" annual elective deferral ($15,500 in 2007) -- subject to the overall "100% / $40,000 rule" (plus catch-up for those age 50 or older).
Self-employed Compensation
For owners of incorporated businesses, compensation is fairly easy to determine: its the amount that shows up on the W-2 form issued by the corporation.
In calculating the 25% limit on contributions for self-employed individuals, compensation refers to net earnings from self-employment. Net earnings from self-employment is gross income from the individual's business, minus allowable business deductions. Allowable deductions include one-half of the self-employment tax, and the deduction for contributions to the owner/employee's Solo(k). These must be deducted from the self-employed individual's "gross" income before calculating the contribution to the plan.
This adjustment for contributions to the plan creates some confusion when expressing contributions to the plan as a percentage of income.. For example, an owner's self-employed income before contribution to his Solo(k) is $100,000. A contribution of $20,000, is expressed as a 25% contribution - that is 25% of the $80,000 income after the contribution: $20,000 / ($100,000 - $20,000). So, a plan that contributes 25% post-contribution income, in effect, contributes only 20% of the owner's pre-contribution income. Use the following fomula to restate post-contribution percentages in pre-contribution terms:
pre-contribution % =
|
post-contribution
1 + post-contribution %
|
Example: Travis Jackson, a sole proprietor, sets up a Solo(k) and he wants to contribute 15% of his self-employed compensation. As an owner, Jackson's contribution on his own behalf is based on the business' net income less one-half of the self-employment tax and the amount of his contributions to the plan. The net earnings of the business this year are $131,000. This represents earnings after business expenses, but before any contribution to Jackson's Solo(k). The self-employment tax this year is $8,800. The deductible contribution for Jackson is $16,512:
Net business earnings: $131,000
less one-half of self-employment tax: - 4,400
Net after self-employment tax: $126,600
multiply by reduced percentage x 13.0435%
Profit-sharing contribution $ 16,512
Jackson's nominal rate of contribution 15% is reduced to 13.0435% using the formula described above (15% divided by 115%).
MAXIMUM CONTRIBUTIONS
Corporations
For incorporated business owners, Solo 401k plan contributions will generally be based on the business owner's wages as reported on IRS Form W-2. (Incorporated business owners should be sure to refer to their plan documents as the exact definition of compensation can vary slightly from one plan document to the next. Owners of Subchapter S corporations must base their contributions on Form W-2 income and may not base Solo 401k plan contribution on pass through profits.)
Once the incorporated business owner's wages are determined (or estimated in the case of advance planning), the maximum contribution is found as follows.
Step 1: Determine Maximum Salary Deferral
Maximum Salary Deferral = Lesser of annual Elective Deferral Limit or Total Wages
Total Wages are limited to a maximum of $225,000 (in 2007).
The Elective Deferral Limit is $15,500 in 2007
Step 2: Determine Maximum Profit Sharing Contribution.
Maximum Profit Sharing Contribution = 25% x Total Wages
Step 3: Calculate Maximum Solo 401k Contribution
Maximum Solo 401k Contribution = Maximum Salary Deferral + Maximum Profit Sharing Contribution
Note: The maximum Solo 401k plan contribution cannot exceed the "100%/$40,000" rule. For 2007 the inflation adjusted limit is $45,000 (exclusive of any "catch-up" contributions) or 100% of Total Wages.
Example: Charles Tanner is the sole owner and employee of Leather Works, Inc., a Subchapter S corporation. Based on his tax advisor's recommendation, Charles intends to draw a salary of $50,000 (Form W-2 wages) from the company during 2007. Based on estimated wages of $50,000 during 2007, Charles' maximum Solo 401k plan contribution for 2007 would be calculated as follows:
Step 1: Determine Maximum Profit Sharing Contribution
Maximum Profit Sharing Contribution = 25% x Total Wages
Maximum Profit Sharing Contribution = 25% x $50,000
Maximum Profit Sharing Contribution = $12,500
Step 2: Determine Maximum Salary Deferral
Maximum Salary Deferral = Lesser of $15,500 or Total Wages
Maximum Salary Deferral = $15,500
Step 3: Calculate Maximum Solo 401k Plan Contribution
Max. Solo 401k Plan Contribution = Max. Profit Sharing Contribution + Maximum Salary Deferral Max. Solo 401k Plan Contribution = $12,500 + $15,500
Max. Solo 401k Plan Contribution = $28,00
Based on estimated W-2 wages of $50,000, Charles could contribute up to $28,000 to an Solo 401k plan for 2007. This level of contribution does not violate the 100%/$40,000 rule -- it does not exceed the inflation-adjusted limit of $45,000 in 2007 or 100% of his $50,000 "compensation" (wages reported on his W-2). In addition, if Charles is age 50 or older in 2007, he will qualify for a "catch up" contribution of $5,000 in the form of a salary deferral contribution, thereby bringing his maximum contribution amount up to $33,000.
Sole Proprietors
For sole proprietors, the figures needed to calculate a maximum contribution under an Solo 401k plan are the
sole proprietor's net profits (from IRS Form 1040, Schedule C) and his or her self-employment taxes (from IRS Form 1040, Schedule SE). Recall that the maximum 401k plan contribution is comprised of two components: an employer profit-sharing contribution and an employee salary deferral contribution. Once the net profit and SE tax figures are determined (or estimated in the case of advance planning), the maximum Solo 401k plan contribution is found as follows:
Step 1: Determine Maximum Salary Deferral
Maximum Salary Deferral = Lesser of annual Elective Deferral Limit or Modified Net Profit
The annul Elective Deferral limit is $15,500 in 2007 -- plus a catch-up provision of $5,000 for those age 50 or older.
Step 2: Determine Modified Net Profit.
Modified Net Profit = Net Profits - ½ Self-Employment Tax
The Modified Net Profit is limited to a maximum of $225,000 (in 2007) -- the same "compensation" limit that applies to employee compensation.
Step 3: Determine Maximum Profit Sharing Contribution.
Maximum Profit Sharing Contribution = Modified Net Profit x 20%
(20% of pre-contribution income = 25% of post-contibution income, using the formula above)
Step 4: Calculate Maximum Solo 401k Contribution
Maximum Solo 401k Contribution = Maximum Salary Deferral + Maximum Profit Sharing Contribution
Note: The maximum total Solo 401k plan contribution cannot exceed 100% of the business owner's Adjusted Net Business Income (Net Profits - ½ Self-Employment Tax - profit-sharing contribution).
Example: India Ink, age 37, is a sole proprietor who estimates that she will have approximately $110,000 in net profits from her business during 2007. India estimates that her self-employment taxes for 2007 to be $14,000. Based on this information, India calculates her estimated maximum Solo 401k plan contribution for 2007 as follows:
Determine Modified Net Profit
Modified Net Profit = $110,000 - ½ ($14,000)
Modified Net Profit = $110,000 - $7,000
Modified Net Profit = $103,000
Determine Maximum Salary Deferral
Maximum Salary Deferral Contribution = Lesser of $15,500 or $103,000
Maximum Salary Deferral Contribution = $15,500
Step 3: Determine Maximum Profit Sharing Contribution
Maximum Profit Sharing Contribution = 20% x $103,000
Maximum Profit Sharing Contribution = $20,600
Step 4: Calculate Maximum Solo 401k Plan Contribution
Max. Solo 401k Plan Contribution = Max. Profit Sharing Contribution + Maximum Profit Sharing Contribution
Max. Solo 401k Plan Contribution = $15,500 + $20,600
Max. Solo 401k Plan Contribution = $36,100
Based on estimated business profits for 2007 of $110,000, India could contribute up to $36,100 to an Solo 401k plan for 2007. This level of contribution does not violate the 100%/$40,000 rule -- it does not exceed the inflation-adjusted limit of $45,000 in 2007 or 100% of her $85,000 "compensation" ($110,000 - $4,400 - $20,600).
If India was age 50 or older in 2007, she would be eligible for an additional "catch up" contribution of $5,000 in the form of a salary deferral contribution, bringing her maximum contribution amount up to $41,100.
Partnerships
Partners calculate their contributions in a similar fashion, based on their share of business profits. For partnerships, the figures needed to calculate a maximum contribution under an Solo 401k plan are:
the individual partner's net profits (from IRS Form 1065, Schedule K-1) and the partner's self-employment (SE) taxes (from IRS Form 1040, Schedule SE). Recall that the maximum Solo(k) plan contribution is comprised of two components: an employer profit sharing contribution and an employee salary deferral contribution. Once the net profit and SE tax figures are determined (or estimated in the case of advance planning), the maximum Solo 401k plan contribution may be determined as follows.
Step 1: Determine Maximum Salary Deferral
Maximum Salary Deferral = Lesser of annual Elective Deferral Limit or Modified Net Profit
The annaul Elective Deferral limit is $15,500 in 2007 -- plus a catch-up provision of $5,000 for those age 50 or older.
Step 2: Determine Modified Net Profit.
Modified Net Profit = Net Profits - ½ Self-Employment Tax
The Modified Net Profit is limited to a maximum of $225,000 (in 2007) -- the same "compensation" limit that applies to employee compensation.
Step 3: Determine Maximum Profit Sharing Contribution.
Maximum Profit Sharing Contribution = Modified Net Profit x 20%
(20% of pre-contribution income = 25% of post-contibution income, using the formula above)
Step 4: Calculate Maximum Solo 401k Contribution
Maximum Solo 401k Contribution = Maximum Salary Deferral + Maximum Profit Sharing Contribution
Note: The maximum total Solo 401k plan contribution cannot exceed 100% of the partner's Adjusted Net Business Income (Net Profits - ½ Self-Employment Tax - profit-sharing contribution).
Example: Tom, Dick and Harry are partners in a microbrewery. The partnership agreement indicates that Tom is a 40% owner, Dick and Harry each own 30%. For 2007, Acme's accountant has estimated the brewery will have profits of approximately $300,000. Based on this estimate, the 2007 self-employment taxes should be $14,545 for Tom, and $10,980 for Dick and Harry.
The maximum contribution that could be made to an Solo 401k plan for Tom (40% owner) is found as follows:
Step 1: Determine Modified Net Profit
Modified Net Profit = $120,000 - .5($14,545)
Modified Net Profit = $120,000 - $7, 273
Modified Net Profit = $112,727
Step 2: Determine Maximum Salary Deferral
Maximum Salary Deferral = Lesser of $15,500 or Modified Net Profit
Maximum Salary Deferral = Lesser of $15,500 or $112,727
Maximum Salary Deferral = $15,500
Step 3: Determine Maximum Profit Sharing Contribution
Maximum Profit Sharing Contribution= 20% of Modified Net Profit
Maximum Profit Sharing Contribution= .20 x $112,727
Maximum Profit Sharing Contribution = $22,545
Step 4: Calculate Maximum Solo 401k Plan Contribution
Max. Solo 401k Plan Contribution = Max. Salary Deferral + Max. Profit Sharing Contribution
Max. Solo 401k Plan Contribution = $15,500 + $22,545
Max. Solo 401k Plan Contribution = $38,045
The maximum contributions for Dick and Harry (30% owners) are:
Step 1: Determine Modified Net Profit Modified Net Profit = $90,000 - .5($10,980)
Modified Net Profit = $90,000 - $5,490
Modified Net Profit = $84,510
Step 2: Determine Maximum Salary Deferral
Maximum Salary Deferral = Lesser of $15,500 or Modified Net Profit
Maximum Salary Deferral = Lesser of $15,500 or $84,510
Maximum Salary Deferral = $15,500
Step 3: Determine Maximum Profit Sharing Contribution
Maximum Profit Sharing Contribution= 20% of Modified Net Profit
Maximum Profit Sharing Contribution= .20 x $84,510
Maximum Profit Sharing Contribution = $16,902
Step 4: Calculate Maximum Solo 401k Plan Contribution
Max. Solo 401k Plan Contribution = Max. Salary Deferral + Max. Profit Sharing Contribution
Max. Solo 401k Plan Contribution = $15,500 + $16,902
Max. Solo 401k Plan Contribution = $32,402
For those partners age 50 or older in 2007, they would be eligible for an additional "catch-up" contribution of $5,000 in the form of a salary deferral contribution.
Other Considerations
If the business hires non-family employees in the future the Solo 401k will have to be converted into a "regular" 401k when those employees become eligible to participate -- subjecting the plan to the non-discrimination rules and other adminstrative hurdles. Plan documents should address this possibility if the owner contemplates hiring non-family employees. Generally, under federal law, the business is permitted to exclude the following types of employees from coverage under a 401k plan:
employees under age 21, employees with less than one year of service, employees who work less than 1,000 hours per year, union employees covered by collective bargaining agreements, and certain nonresident alien employees. Contirubutions are allowed only after the plan documents have been adopted, i.e., there are no retroactive contributions based on compensation that has been paid to the "owner-employee" in the past. In the case of incorporated businesses, the owner-employee's compensation is the salary or wages paid by the corporation -- and found on the owner-employee's W-2 form. An written salary deferral election must be filed with the employer prior to when the deferred wages or salary would have been paid. In the case of unincorporated businesses (sole proprietorship or partnership) the compensation is based on the business' "net profits" (see examples above). The IRS considers those business profits to be received by the owner on the last day of the business' tax year (in many cases, December 31) A written salary deferral election must be filed prior to this time for proprietors and partners to defer into a Solo 401k.
As with all qualified plans, the Solo 401k plan documents must be filed no later than the end of the business' tax year.
Loans
Beginning in 2002, owner-participants may borrow funds from their 401k accounts. Prior to 2002 this was a prohibited transaction. Solo(k) plans may permit loans to plan participants (namely the business owner), subject to the same rules as any other 401k: up to $50,000 or one-half of the vested interest in the account, secured by collateral, quarterly amortization, five-year repayment, reasonable rate of interest, etc.