For a long time, self-employed workers did not consider a one-participant 401(k) plan because of the cost and effort to put the plan into place for one person. But now there is a feasible alternative for the self-employed with a great advantage over other plans.
The same rules govern a one-participant 401(k) plan as those for multiple employees. Contributions are still made on a pre-tax basis up to a specific limit. For 2015 the maximum that can be placed in the plan is $18,000, or $24,000 if you are 50 years old or older, and your amounts can grow with no actual tax due until you make a withdrawal.
Employers can have matching contributions up to a specified limit. Therefore, you can profit from employer and employee contributions. Under a Simplified Employee Pension (SEP), the maximum deduction can not be more than the lesser of 25% of your compensation or $53,000. The amount is $59,000 if you are 50 yrs old or older. The extra $6,000 is allowed for catch up contribution. The most compensation you are allowed to take into account in 2015 is $265,000.
The benefit of a one-participant 401(k) plan is that it offers elective deferrals that do not count toward the 25% income cap, but the dollar limit of $53,000 does. If you are self-employed and you make $110,000 annually, you can place up to 25% of your compensation, which is $27,500. This may seem like the way to go but you could have more in retirement if you opt for a one-participant 401(k) plan.
In essence, if you set up a one-participant 401(k) instead of a Simplified Employee Pension, you can as the employer match your own money. An example of this would be to defer $18,000 as an employer and match it as the employee, since you are the employee and the owner. You could have $7,500 more than a SEP if you choose to do a one-participant 401(k). With a one-participant 401(k) you can borrow against it or take a hardship withdrawal if needed. The funds from a qualified plan from a previous company can be rolled over into the 401(k) also. Since contributions are discretionary, the owner can cut back or omit contributions all together if the business year is not good.
It could also be great when a married couple works together. The working spouse is treated as an exception to the one-worker rule and the contributions can equal those of the business owner. Even so, if the plan is called a one-participant 401(k) , other employees you hire that meet the eligibility requirements must be covered.
If you have additional questions regarding retirement plans, contact your financial planner or call us for a referral to someone we trust.
For more information visit CPA Practice Advisor or IRS.gov.
