Are you a Small Business Owner? Are you Self-Employed? The same retirement plan options available to companies with 10, 20 or 200 employees are also available for your business. Many Small Business Owners may be more familiar with a Simplified Employee Pension (SEP) IRA. With a SEP you can deduct up to 25% of your earned income. However, it may make sense to look at a one-participant 401(k) plan. This combines a traditional employee retirement savings plan with a small business profit-sharing plan. This may make for a larger overall deduction comparable to the same earned income.
Contribution limits in a one-participant 401(k) plan – The business owner wears two hats in a 401(k) plan: employee and employer. The owner can contribute both:
- Elective deferrals which reduce compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
- $19,000 in 2019 ($19,500 in 2020), or $25,000 in 2019 ($26,000 in 2020) if age 50 or over; plus
- Employer contributions up to:
- 25% of compensation, as defined by the plan, with special calculations for sole-proprietor and partnership entities
Total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed the lessor of: 100% of compensation, or $56,000 for 2019; ($57,000 for 2020). In addition, the 401(k) limit on elective deferrals is an individual, calendar year limit, not a limit for each plan. If a business owner is also employed by another company and participates in its 401(k) plan, the total of all elective deferrals cannot exceed the annual contribution limit.
Contribution limits for self-employed individuals – If the business entity is a sole-proprietor or partnership, a special computation must be made to determine the maximum employer contribution. When calculating the contribution, it is a circular calculation. Compensation, or “earned income,” is the net earnings from self-employment after deducting both your share of the employer allocation and one-half of your self-employment tax.
Note: The IRS Publication 560 provides rate tables and worksheets for figuring your allowable contribution rate and tax deduction for your 401(k) plan contributions.
Testing in a one-participant 401(k) plan – A business owner with no common-law employees doesn’t need to perform nondiscrimination testing for the plan, since there are no employees who could have received benefits under the plan. The no-testing advantage vanishes if the employer hires employees. If the business hires employees, the plan must satisfy all coverage and non-discrimination requirements as any other 401(k) plan, once they become eligible.
Note: The Plan Document should be flexible enough to protect the employer if employees are hired in the future.
Reporting Requirements (Form 5500) – If plan assets exceed $250,000 at the end of a plan year, the plan will be required to file a Form 5500-EZ, or Form 5500-SF until the plan is terminated and all assets are disbursed. A one-participant 401(k) plan with fewer assets is exempt from the annual filing requirement. When determining the $250,000 threshold, all plans of the entity are considered; if you sponsor more than one plan, the filing requirement starts when the sum of the assets combined in all plans exceeds $250,000 at year-end.
Note: Failure to file Form 5500 when required can result in substantial penalties on audit.
Most Small Business Owners are familiar with a SEP IRA. Planning for retirement with a 401(k) plan can offer a great degree of flexibility. The basics start with a 401(k) plan; and adding a defined benefit pension plan can greatly increase the potential tax deduction available to a successful business owner. Whether you are adopting a plan for the first time, or have one that needs cleaning up, EJReynolds is here to help.