Financial advisors with clients who have owner-only businesses, or who fit that description themselves, may find appeal in a variation of the popular corporate 401(k) plans that have been around for more than 20 years. The plan, called a solo 401(k) or an individual 401(k), can be used for incorporated and unincorporated businesses, including C corporations, S Corporations, single member LLCs, partnerships and sole proprietorships. Real estate brokers, consultants, attorneys, manufacturers representatives, interior designers, retirees starting a new business and other professionals who work by themselves are prime candidates.
Under new rules created by changes in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that became effective in January 2002, a business consisting of only an owner, or an owner and his or her spouse, can make greater tax-deductible contributions than under a SEP-IRA or SIMPLE IRA. Contributions are discretionary, so owners can vary them from year to year or skip them altogether.
This year, total contributions to a solo 401(k) cannot exceed 100% of pay, up to a maximum of $41,000 for those under age 50. This amount includes salary deferrals of up to $13,000 ($16,000 if age 50 or older), plus an employer contribution of up to 25% of pay (20% for self-employeds). While SEP-IRA contributions also max out at $41,000, they are limited to 25% of pay (20% for self-employeds). And, SEP-IRAs do not provide for additional catch-up contributions. With a SIMPLE IRA, employees under age 50 can defer up to $9,000 this year, while those age 50 or older can contribute up to $10,500. The employer can make additional required contributions.
Under these guidelines, an individual under age 50 with earned income of $100,000 who is the sole employee of an incorporated business could contribute a maximum of $25,000 to a SEP-IRA, $12,000 to a SIMPLE IRA, and $38,000 to a solo 401(k) (consisting of a $13,000 salary deferral plus an employer contribution of $25,000). Someone with $150,000 in W-2 income could contribute as much as $37,500 to the SEP-IRA, $13,500 to the SIMPLE IRA, and $41,000 to the solo 401(k).
The ability to make generous contributions at lower income levels means that business owners who want to catch-up on retirement contributions can do so more quickly than they could with a SEP-IRA or a SIMPLE IRA. "Someone in his fifties with $100,000 in income could put away $41,000 for retirement this year with an individual 401(k)," says Barry Milberg, Milberg Consulting LLC, a retirement plan consulting and administration firm. "That would not be possible with a SEP or SIMPLE." Milberg says that many of his clients who had those plans have rolled the assets into an individual 401(k).
One group that won't find these plans appealing is businesses that have employees or anticipate adding them. Contributions are 100% vested immediately, and an owner who gives himself the maximum employer contribution is required to contribute the maximum for employees. Additionally, a number of IRS requirements must be met if a plan includes employees. And because the plans can take no more than $205,000 of compensation into account, they may not be appropriate for extremely high-earning entrepreneurs interested in sheltering more than $41,000 a year. In these cases, a defined benefit plan arrangement may be more appropriate. (For more information on defined benefit plans, see the article titled "Dusting Off Defined Benefit Plans" in the July 2004 issue of Financial Advisor.)
The Rollover Hook
Retirement plan experts say that in many cases flexibility, rather than higher contribution levels, is the major draw of these plans. Individual 401(k) plans can accept rollovers from virtually any type of retirement plan, including a corporate 401(k) or an IRA. Depending on the plan administrator, participants may also have the flexibility to invest in real estate and other non-traditional assets. They can also borrow the lesser of 50% of the plan balance, or $50,000. Both loans and direct investments in real estate are prohibited in an IRA.
The loan feature is a strong draw for clients who may want access to their money without incurring the taxes and penalties associated with taking an early distribution from a rollover IRA. "A lot of people are using an individual 401(k) to consolidate existing retirement accounts, then borrow against the plan," says Chris J. Brown, vice president and director of retirement market research at Financial Research Corporation, Boston. "It's ideal for someone who has retired and set up a small business and wants to use the money to help get things off the ground."
Jodie Hale, vice-president of retirement plan marketing at Pioneer, says that her firm has seen a lot of rollover dollars move into its Uni-K Plan. Pioneer's offering, which is also sold under a private label arrangement through Merrill Lynch, now has about 9,000 plans and $250 million in assets.
"These plans have two big hooks," she says. "The first is the ability to consolidate assets from virtually any kind of retirement plan. The second is the loan feature. Midlife job changers or those who have been laid off are reassured when they know that they can tap into their retirement savings when they start a business."