An Individual 401(k) Plan allows a self-employed professional, with no employees other than their spouse, to save tax-free money for their own retirement. A self-employed professional and their spouse may each contribute a total contribution equal to the Section 415 limits as indexed by the IRS. These are the same limits that apply to a traditional 401(k) Plan.
The annual contributions into an Individual 401(k) are made up of 2 parts: a tax deductible salary deferral, and an additional tax deductible profit sharing contribution of up to 25% of compensation (slightly less if unincorporated or 100% of the 415 limit, whichever is less).
Recently, Individual 401(k) plans have become the most popular of small business, employer sponsored retirement plans. These types of plans offer:
Contribution Flexibility
Each year the Plan’s funding is completely discretionary. You can increase or decrease contributions to maximize profitability. Individual 401(k)s allow salary deferral limits, catch up provisions*, and one hundred percent vested contributions options.
*Catch-up Provisions
Individuals age 50 or older may contribute additional salary deferrals. These do not count towards the maximum total contribution limit.
Tax-Free Loans
Just like traditional 401(k) plans, you can take tax-free loans from your Individual 401(k) plan. Tax-free loans from the Individual 401(k) may be up to 50% of the total 401(k) value with a $50,000 maximum are permitted. Loans are then repaid according to the terms of the loan amortization schedule.
Asset Consolidation
With an Individual 401(k) plan, you can consolidate (roll-over) assets from all of your other retirement plans including: Traditional IRA, Traditional 401(k) Plan, SEP IRA, SIMPLE IRA, Profit Sharing Plan, Money Purchase Plan, Defined Benefit Plans, 403b Plans, and Rollover IRAs.
Who Qualifies?
Individuals who are self-employed and have either no other employees, or employ only their spouse, are the best candidates for an Individual 401(k). Partners and their spouses are also eligible for the plan. This type of plan may be the perfect retirement plan solution for businesses such as: professional general contractors, freelance photographers and/or writers, consultants, plumbers, electricians, small physician offices, and similar “micro” businesses. Sole proprietors, partnerships, S-corporations, and C-corporations all qualify.
The Investment Entity
The Individual 401(k) Plan trust must reside with one financial institution, and the investments therein must be held within individually allocated accounts. The investment entity may impose a separate charge for the required services, and must:
1) Provide a minimum of quarterly participant statements,
2) Code and track dollars deposited by source (i.e., deferral, profit sharing and rollover), and
3) Perform IRS 1099-R distribution reporting and withholding.
Savings Example
Starting to invest for retirement early assures the greatest return on investment, but it’s never too late to begin. Let’s review two scenarios to show how to best maximize your retirement savings:
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OWNER A Invests $2,000 a year for 10 years and stops. Total Investment = $20,000 Rate of Investment Return = 8%* Thirty Year Result= $314,870 |
OWNER B Waits 10 years before investing, and then puts away $2,000 a year for 30 years. Total Investment = $60,000 Rate of Investment Return = 8%* Thirty Year Result = $244,692 |
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GROWTH DIFFERENCE OF $70,178 * 8% is actually a low rate-of-return; most mutual funds will provide between a 10-18% rate-of-return, depending on the diversity of the investment. |
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Save for Retirement While Saving Taxes
By contributing to an Individual 401(k) retirement plan with profit sharing and/or before-tax salary reduction you can reduce your gross taxable income, thereby incurring significant tax savings. After-tax contributions are a tax-deductible business expense. In addition, you are not responsible for any taxes on your retirement plan earnings until the time of withdrawal; usually during retirement.
Contribution Limits
For 2006 the contribution limits for a 401(k) are as follows:
|
Contribution |
Dollar Limit |
|
401(k) Elective Deferrals |
$15,000 |
|
Annual Defined Contribution Limit |
$44,000 |
|
Annual Compensation Limit |
$220,000 |
|
Catch-Up Contribution Limit |
$5,000 |
In addition, for 2006 you can add an additional $20,000 more in salary deferrals to the plan.
The contribution levels of an Individual 401(k) may be more than other small business retirement plans such as Traditional IRA, Roth IRA, SEP IRA, Money Purchase, or Profit Sharing plans.
Trustee Requirement
Individual 401(k) plans require a trustee to hold the assets on the business owner’s behalf. You may act as your own trustee as long as you maintain proper record-keeping, and maintain a proper Plan Document (the plan administrator may provide these documents as part of setting up the plan).
Exclusions
If you employ any part-time employees, you may be able to exclude them from the plan using the following federal guidelines:
- Employees under age 21
- Employees with less than one year of service
- Employees working less than 1000 hours per year