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."

For someone under age 591/2 who has left a job and is strapped for cash, the loan feature can be a way to get money out of a 401 (k) without facing the penalties and taxes associated with a premature retirement plan distribution. The only requirement to establish an account is that you have self-employment income, so someone who is between jobs and doing consulting work would qualify. Loans must be repaid according to IRS guidelines as they would with a corporate 401(k), or become subject to taxes and penalties.

Developing Market

Brown says that about 50 financial services firms, including "about half of market leaders," now offer solo 401(k)s under a variety of brand labels such as the Scudder Personal (k), the Pioneer Uni-K, the AIM Solo 401(k), and Waddell & Reed's Exclusive K. He predicts continued growth for such products. "Financial advisors are waking up to the benefits these plans can offer small businesses," he says. "With just 50,000 of these plans adopted to date, investment manufacturers and distributors still have an opportunity to get in during the early stages of what will be a rapidly accelerating and increasingly lucrative market."

Financial Research Corporation predicts that the adoption of 40,000 to 50,000 new plans this year, and growth in assets from $1.5 billion to $3 billion by year-end. Pioneer's Hale also sees growth opportunities. "There are 17 million people who file as owner-only businesses, so the market for these plans is huge and largely untapped," she says.

Hale says the plan is fairly easy and inexpensive for the business owner to set up and administer, since it only covers owners and spouses. Pioneer charges no set-up fee, and a fee of $100 per participant per year. Each loan is also subject to an additional $100 charge. No IRS filing is required until plan assets exceed $100,000. Once assets exceed that level, the IRS requires an annual Form 5500 filing. The IRS's Form 5500EZ is suitable for most small 401(k) plans. At Pioneer, an optional Form 5500 preparation service costs $250.

Perhaps the main drawback of these plans is that they are still in the testing stage and not widely available. The most comprehensive listing of solo 401(k) vendors, located at the web site 401khelpcenter.com, includes several recognizable names but does not list many large fund firms or brokerage houses.

Chris Brown says that because these plans are so new, some firms are taking a wait-and-see attitude to gauge how the market develops. Some of their hesitation may stem from concerns about the administration aspect of the plans, made complicated by the loan feature and multiple sources of rollover assets. While some firms will develop in-house administration capabilities, others will outsource that function, says Brown. He believes the market will see a number of new products come out in the fourth quarter of this year and the first quarter next year, the top sales periods for retirement accounts.

As it stands now, product choices and investment options offered by financial services firms remain fairly limited. At Pioneer, investors can choose from among 49 of the firm's mutual funds. But they can't invest in funds from other families, or in real estate and other nontraditional assets. And while the Pioneer's Uni-K permits loans, some other plans do not.

Third-party administration firms offer a more flexible alternative to fund company offerings, but they are also more expensive. Milberg's firm charges $1,500 to set up a solo 401 (k), a fee that includes setup, plan design, the plan document, and compliance services. After the first year, the annual fee is $850. Milberg, who specializes in custom-tailored pension and retirement plans for high-income professionals such as hospital-based physicians and real estate agents, says his clients can invest in virtually any mutual fund or security they want, or in nontraditional investments such as real estate. "I generally don't recommend putting real estate into these plans because that asset already has inherent tax advantages," he says. "I also try to discourage borrowing. A lot of times, people don't repay the loan, which creates a taxable event. It's important to remember that these are, first and foremost, retirement savings plans."