One-Person 401k's May Make Sense for Owner-only Businesses

By Clifton Linton
Senior Writer, mPower

"How can I set up my own 401k?" is a common reader question.

We suspect that most people who ask are rank-and-file employees who are dissatisfied in some way with their 401k at work. In that case, the answer is, "Sorry, you can't. You're stuck with the plan your employer offers."

But, if you are self-employed, rule changes contained in the 2001 tax bill may make a one-person 401k plan a viable alternative to other retirement plans for small businesses. One catch is that it likely wouldn't be cost-effective if your business has any employees who would be eligible for the plan.

Contributions to a one-person 401k plan are based on revenue generated by your business. If you participate in any other plan, with another employer, you must coordinate one-person 401k contributions with that plan so you meet the IRS limits described below.

Here's a look at the 401k plan for one.

Who It's For

The solo 401k plan is suitable for businesses in which the owner or owners are the only employees.

This plan works in a situation where there are "no common law employees," said Hugh Bromma, CEO of Entrust Administration Inc. of Oakland, Calif., an IRA administration firm that also offers one-person 401k plans. This means the plan can be used by the business owner, his or her spouse if working at the business, and any partners in the business and their spouses who work at the business. It could work well for businesses such as sole-practitioner professionals, partnerships, manufacturer's representatives, small retail owners, freelance writers, computer consultants and electricians, to name a few.

"The big caveat is if the owner decides to hire someone -- the picture changes radically," Bromma added. That's because an employer-employee relationship adds new layers of administrative, fiduciary and financial responsibility. For example, for a very small firm with an owner-employer and a few employees, the employer will likely be required to make mandatory contributions to the employees' 401k accounts in order for the plan to pass its nondiscrimination tests. These tests determine if the plan is offered fairly to all employees.

New Limits

The biggest reason why you might consider opening a one-person 401k plan is that it may offer higher contribution limits than other retirement plans available for small businesses. In this regard, the two most significant changes contained in the 2001 tax bill with respect to retirement plans were:

Raising the total individual contribution limit, including employer profit-sharing and/or matching contributions, to the lesser of $40,000 or 100 percent of income. Previously it was the lesser of $30,000 or 25 percent of income.

Changing the total plan contribution limit. In 2002, employer contributions to the plan may not exceed 25 percent of total payroll. The significance here is that employee contributions are excluded from this limit. Previously, total plan contributions (both employer and employee) could not exceed 15 percent of total payroll of eligible employees.

In a large business, with many folks eligible for the plan, the 15 percent total plan limit was rarely hit because many employees either didn't participate or contributed far below their maximum allowed limit. Some employers even capped employee contributions at 15 percent of salary to avoid exceeding this limit. But, for a one-person shop, it could be easy for the owner to hit the 15 percent limit with his or her contributions.

"With a one-person firm, that person is the company. They couldn't exceed the 15 percent limit," said James Kieckhaefer, senior vice president with Wachovia Securities in Brookfield, Wis. "The 25 percent of compensation limit didn't work for that person."

Prior to 2002, the only way a sole proprietor could contribute up to 25 percent of income was to maintain a 401k, a profit-sharing or SEP plan (in which the maximum contribution was 15 percent of payroll) and a money purchase pension plan (which could be used to make up the rest). Once instituted, the money purchase pension plan contribution is required to be the same each year. If you want to reduce it you must notify the IRS. For a small business with uncertain income, this requirement is onerous.

Annual contributions are not required in the one-person 401k plan.

Folks with one-person 401k plans may also take advantage of the new age-50 catch-up contributions, provided they qualify.

The biggest benefits of this plan go to those who earn up to $160,000, said Linda Brown, assistant vice president with the retirement and education product division of AIM Management Group Inc. This is because 25 percent of $160,000 is $40,000, the maximum limit. If you earn below $160,000 you can contribute 25 percent of your income as the employer, plus up to $11,000 (the maximum employee contribution) to get up to $40,000, rather than simply being limited to 25 percent of salary. A person 50 or older could contribute an additional $1,000 catch-up contribution, for a total of $41,000 in 2002.

Advantages

In addition to the higher limits, the one-person 401k has other advantages. These include:

Low paperwork requirements, including being exempt from discrimination testing as long as you have no eligible employees. The only annual paperwork you may be required to file is the IRS Form 5500, which applies when plan assets exceed $100,000. The IRS provides a form 5500EZ that is suited to small 401k plans.

The ability to take a loan. SEP plans and SIMPLE IRAs, popular retirement plans with small businesses, don't allow loans, although a profit-sharing plan could.

Responsibilities

Setting up a one-person 401k entails more responsibility than a SEP or SIMPLE IRA.

For one thing, the plan needs a trustee to hold the assets on your behalf. Many people act as their own trustee, but if you decide to do this you need to be very attentive to detail.

"If you are your own trustee, you need to follow the rules carefully," Bromma said. "What happens often is that people don't keep proper records."

If you set up a one-person 401k, you need to prepare and retain records concerning the plan and its activities. The plan also requires a plan document spelling out how the plan is operated. Most folks use standard plan documents, and many one-person 401k plan providers include these in the cost of setting up the plan.

You can hire services and firms to do the recordkeeping jobs to save you the time and hassle, but of course this will cost extra.

Setting One Up

The one-person 401k is a fairly new retirement tool and isn't widely offered by financial services firms.

Take Charles Schwab & Co. Inc. for instance, one of the largest providers of IRAs. The one-person 401k "is something we are looking in to," said Rene Kim, vice president, retirement products with Schwab.

Still, an Internet search turned up a number of firms, such as Salomon Smith Barney, John Hancock Funds, AIM and Pioneer Investment Management Inc., that advertise these plans. You will need to do your own research to find the right plan for you.

A 401k, like any other financial service, does have a cost. And the cost rises depending on the services you purchase.

Most one-person 401k plans charge a one-time set up fee. This can range in price from $150 to $300 or more. And you will likely have to pay an annual maintenance fee, with the amount depending on the services you purchase from the plan provider.

For instance, if you decide you are willing to prepare all the paperwork and do all the recordkeeping for the plan, you could pay as little as $10 a year. But, if you want another firm to do this job for you it can run $150 a year or more.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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