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The One-Person 401(k) Strategy

Tax professionals are always looking for tax deductions for their highly-compensated clients. In 2007, the new strategy of the one-person 401(k) plan was born.

September 13, 2007
by Deborah Ziolkowski

Prior to 2002, a 401(k) plan was not feasible for a self-employed individual or owner-only business. It made more sense to contribute to a SEP IRA or another qualified retirement plan solely through employer contributions up to the allowable limits. Salary deferral contributions added nothing.

In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) created the one-person 401(k) strategy. The one-person 401(k) plan created new opportunities for many self-employed businesspeople to contribute more to a tax-deductible retirement plan than ever before, and to retain the ability to determine their contributions each year.

The tax law changes affecting qualified retirement plans allow a self-employed person to make maximum employer contributions plus salary deferral contributions. The combined contributions resulted in newly-increased individual benefit limits — the new strategy of the one-person 401(k).

In 2007, the one-person 401(k) allows a self-employed person to:

  • Contribute up to 25 percent of compensation plus 401(k) salary deferrals plus catch-up contributions (if age 50 or older).
  • Make total contributions up to the lesser of $45,000 ($50,000 if 50 or older) or 100 percent of compensation.

Basic Rule Changes

A 401(k) plan is a profit-sharing plan designed to accept employee salary deferral contributions (IRC Sections 401(k)(1) and (2)). A salary deferral contribution is the result of an employee’s electing to have his or her compensation reduced by an amount of his or her own choosing, which the employer then contributes to a retirement plan established by the employer. Salary deferral contributions are treated as employer contributions. Thus, they are tax-deductible by the employer and are not taxable to the employee until distributed form the plan.

The one-person 401(k) strategy resulted from several changes in the tax laws enacted under EGTRRA. The most important change was the addition of IRC Section 404(n). Before EGTRRA, salary deferral contributions were included in determining the maximum amount an employer could contribute annually to defined contribution retirement plans as matching or profit-sharing contributions. As a result, employee salary deferrals and employer contributions limited each other. When designing a plan and determining contributions, the employer had to choose between the two. Thanks to Section 404(n), enacted by EGTRRA, salary deferrals are not included in determining the deduction limits of Section 404(a)(3).

Equally important is the addition of IRC Section 415(c)(1). EGTRRA changed this limit to the lesser of 100 percent of compensation or $45,000 (beginning in 2007), which is adjusted annually by the Treasury for cost-of-living increases in $1,000 increments.

The Combination of These Changes

The effects of these changes for 2007 can be summarized as follows:

  • A participant can receive an employer contribution of up to 25 percent of compensation and make a salary deferral contribution of up to $15,500, as long as the total does not exceed the lesser of 100 percent of compensation or $45,000.
  • If a participant reaches age 50 before the end of the plan year, he or she can make an additional salary deferral contribution of up to $5,000, as long as the total does not exceed $50,000. The catch-up contribution may cause the employee’s total contribution (such as with a corporation) to exceed 100 percent of compensation. An unincorporated business is still limited to the 100 percent limit because of deduction limitations.

Example

Bill, age 55, has an incorporated business. How much can he defer into a one-person 401(k) plan if he is paid $100,000 in W-2 salary from his corporation in 2007?

  • Profit Sharing (25 percent of $100,000) $25,000
  • Salary Deferral + $15,500
  • Catch-up for Age 50+ plus $5,000

Total $45,500

When Should a Business Select the One-person 401(k) Plan?

The one-person 401(k) plan is appropriate if the business owner or owners:

  • Wish to contribute more than 25 percent of compensation.
  • Would like to retain flexibility to determine contribution amounts from year to year.

If business owners do not wish to make contributions exceeding 25 percent of their compensation, an SEP IRA or profit-sharing plan may be sufficient. The SEP IRA, is typically less costly than the one-person 401(k) plan and allows up to a 25 percent contribution.

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Deborah Ziolkowski recently received her Master’s of Science in Taxation at Golden Gate University and has her own tax and accounting practice in Mill Valley, CA. She has been a tax professional for over 10 years.