The Tax Reform Act of 2001 (officially called the Economic Growth and Tax Relief Reconciliation Act) is now providing employee-free business owners with better retirement benefits. The new rules allow these business owners to set up a 1-person 401(k) plan (ie, individual 401(k) plan) to which they can contribute up to 25% of their income annually as a discretionary, tax-deductible employer contribution.
Participating business owners can also make an additional $11,000 pretax elective deferral. And if you're over age 50, the catch-up rules allow for a contribution of another $2000 (this will increase $1000 every year until 2006). In the past, sole business owners usually preferred a simplified employee pension (SEP) plan as the strategy for funding retirement. However, the new 1-person 401(k) plan provides significantly enhanced bene- fits. Following is a list of the benefits:
â€¢ Higher contribution limits. Individual 401(k) plans let you defer more money than an SEP. For example, let's say you're a sole proprietor with a net profit of $145,000. Now, if you chose an SEP plan, your maximum deduction would be $29,000. On the other hand, if you chose a 1-person 401(k) plan, you could contribute up to $29,000 plus an elective deferral of $11,000, bringing your total contribution to $40,000. And, if you are over age 50, you can contribute an additional $2000â€”this catch-up option is not available for SEP plans. Elective deferrals can be 100% of your income, up to the annual maximum.
â€¢ Creditor protection. All 401(k) plans are protected from creditors by federal statute, under the Employee Retirement Income Security Act. Many states do not have statutes that protect IRAs or SEPs from creditors.
â€¢ Rollovers. The law allows you to roll over money from your existing SEP plan, traditional IRA plan, 403(b) plan, or other qualified retirement plans into your individual 401(k) plan.
â€¢ Loans. The 401(k) plans permit loans. SEP plans and IRA plans, however, do not permit their users to borrow money.
â€¢ Compliance testing. The typical 401(k) plan requires that you "test" the plan to make sure it does not unduly favor the highly paid employees. Individual 401(k) plans do not require this testing. They even allow you to have spouses and equal partners on the payroll without requiring any compliance testing. However, if you do hire nonrelated, nonpartner employees in the future, you will be subject to compliance rules.
Even if your business is a sideline, you may still set up a 1-person 401(k) plan and make the contributions as long as total contributions do not exceed $40,000. If you are a physician-investor with no employees other than a spouse or partner, then you may want to consider a 1-person 401(k) planâ€”it's an outstanding strategy for retirement savings.
Stewart H. Welch III, founder of
the Welch Group, has been
rated one of the nation's top
financial advisors by Money,
Worth, and Medical Economics.
He welcomes questions or
comments from readers at 800-709-7100 or
www.welchgroup.com. Reprinted with permission
from the Birmingham Post Herald.