Single-Participant 401(k)

From TaxAlmanac

As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), a new self-employed retirement vehicle was created that allows self-employed persons to make retirement plan contributions as both the employee and the employer of his/her business. These moderately new vehicles are commonly known as Solo 401(k) plans, Self-Employed 401(k) plans, or Individual 401(k) plans. They are primarily designed for the self-employed taxpayer who owns a business in which the only employee is the owner.

Under traditional small business retirement plans (other than SIMPLE and Salary Reduction SEP plans), the maximum annual deductible contribution to the retirement plan is limited to 20% of self-employment income, contributed as the employer. The 2001 Tax Act, however, provides that a self-employed person can make a salary deferral contribution (as an employee) up to the lesser of the elective deferral limit ($14,000 for 2005) or self-employment income, plus an employer contribution of up to 20% of self-employment income. The total contribution (employee and employer), however, is limited to the lesser of self-employment income or an annual overall additions limit ($42,000 for 2005). In order to take advantage of the elective deferral component associated with the tax law change, the sole proprietor must set up a single-participant 401(k).

The example below illustrates the advantages associated with a single-participant 401(k).

Example: Assume that in 2005, a sole proprietor has net earnings from self-employment of $60,000 (after the ½ of SE tax deduction). Under a traditional small business retirement plan, such as a SEP or profit-sharing plan, the most that the taxpayer can contribute to the plan is a $12,000 employer contribution ($60,000 x 20%). However, under a single-participant 401(k) plan, the same sole proprietor can make a $14,000 elective deferral contribution (as an employee) in addition to the $12,000 deductible employer contribution, for a grand total of $26,000.

If the self-employed individual is over age 50, catch-up contributions are also allowed as an elective deferral contribution.

IRS Publication 560 provides a worksheet to assist in determining the deductible amount of contributions to a single-participant 401(k).

Source: Publication 560