Ever wonder if an entrepreneur with no employees can start a 401(k) — just like the “Big Boys?” Meaning, do you have to employees to start a retirement plan? Yes, an entrepreneur or small business person with no employees can, in fact, have a 401(k) plan just like Boeing’s plan, Google’s plan, or Microsoft’s plan. The difference, there is only one participant, the owner.
The “one-participant 401(k) plan” is not a new type of plan. It is a traditional 401(k) plan covering only one employee. The plans have the same rules and requirements as any other 401(k) plan. The surging interest in these plans is a result of the EGTRRA tax law change that became effective back in 2002. The law changed how salary deferral contributions are treated when calculating the maximum deduction limits for contributions to a 401(k) plan. This change created an opportunity for some people to put away additional amounts toward their retirement.
The marketing for this type of plan is aimed at business owners who do not have any employees, other than themselves and perhaps their spouse. Many of the advantages stressed by marketers of these plans vanish if the employer expands the business and hires more employees. No matter what the plan is called, it must meet the rules of the Internal Revenue Code. If employees are hired and they meet the eligibility requirements of the plan and the Code, they must be included.
Under prior law, the employer profit-sharing and matching contributions were combined with the employee deferral when determining the maximum deduction limit of 25% of employees’ compensation. Now, since the tax law change, the employee deferrals are removed from the deduction limit calculation. Only the employer contributions are limited to less than or equal to 25% of the employees’ compensation. The employee deferrals can be made in addition to the employer contributions. Every year the government dictates maximums that can be deferred into 401(k) and it is generally around $19,000. If an employee is age 50 or older, an extra maybe 25% more may be deferred. This extra amount is called a “catch-up contribution.”
These deferrals can be either pre-tax or, if the plan allows, after-tax contributions. The after-tax deferrals are known as designated Roth contributions. We’ve been asked if a participant can defer maximums into both pre-tax deferrals and Roth 401(k)s. The answer is “No.” There is one limit per person for all types of elective deferrals. However, the limit can be split in any ratio between the Roth and the pre-tax elective deferrals.
Another question that we often hear is how salary deferrals are made when a person is self-employed or involved in a partnership. The person doesn’t usually know for certain what their income will be until the end of the year, or later. The final 401(k) regulations address this issue. The regulations state that a partner’s or self-employed person’s income is deemed available to them on the last day of their taxable year. And since an employee must have a deferral election in place before compensation is available, a self-employed person may not make a cash or deferred election with respect to compensation for a partnership or sole proprietorship taxable year after the last day of that year. If a partnership provides for cash advance payments paid to the partner during the taxable year that is based on the value of the partner’s services prior to the date of payment (and which do not exceed a reasonable estimate of the partner’s earned income for the taxable year), the individual can defer a portion of these advances even though their final compensation has not yet been determined.
Obviously, if the self-employed person wants to maximize their contribution, they can’t do so until their final compensation has been determined.
That is o.k. as long as the election was in place as of the last day of the taxable year. Bottom line, self employed participants may defer against “advances” or “draws.” Keep in mind that at the end of the plan year, the deferrals still must be tested as an annual addition for the §415 limits. If the test fails then the excess amounts deferred would have to be corrected. Lastly, employer contributions are not required to be made until the due date of the employer’s tax return, plus extensions. So, in the case of a sole proprietor, this is when the 1040 is due — October 15, if an extension was filed.
The IRS is not promoting these plans, nor is it saying these plans are bad. It is simply suggesting that employers use care when looking into any retirement arrangement to be sure the plan they decide on is right for them and that they look not only at the limits that apply to the plan but also at the limits that apply to themselves.
At times retirement plans with no employees make a ton of sense. In effect, an entrepreneur can put in a contribution and the government is paying them to save for their retirement (via the tax deduction). Not a bad deal.
R. Kenner French, the author, has written two books, speaks professionally all over the country, and is a family man. He lives on an island — Bainbridge Island, WA.