Law opens up 401(k) plans to sole proprietors

Friday, August 2, 2002

YOUR BUSINESS: Kathryn Underwood

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About the author
Kathryn Underwood is president of KeyBank's Maine District and is based in Portland. She has about 20 years' experience in financial services, all with KeyCorp subsidiaries and predecessors.

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It's all in the words "self-employed" and in the law.

Under the 2001 Economic Growth and Tax Relief Reconciliation Act that took effect this year, a change to the contribution limits created an opportunity for self-employed business owners to join the rest of the business world in putting aside tax-deferred retirement savings through new individual 401(k) plans.

Before the new law, 401(k) plans for small-business owners were impractical, too complex and costly to set up and maintain. Now, sole-proprietor owners of companies can contribute tax-deferred funds to such plans as both employer and employee, exciting news for America's 13 million sole-proprietor business owners, who can now greatly increase their tax-deferred savings. Individual 401(k) plans are ideal for such professionals as independently practicing attorneys and physicians, Realtors, accountants, consultants and independent contractors, especially those earning $50,000 to $160,000 annually.

Individual 401(k) plans are designed for small-business owners without employees. However, owners of other types of businesses, such as corporations (including both Subchapter S and C Corporations) and limited liability companies (LLCs) that are considered partnerships for tax purposes, can also establish individual 401(k) plans.

To be eligible businesses must:

Have no employees, or have only seasonal or part-time employees who work fewer than 1,000 hours per year,

Be partnerships without employees, or

Be small businesses whose sole employee is the spouse of the owner. Owners of such businesses are finding that individual 401(k) plans offer huge benefits including:

Higher contribution limits than with Keogh Profit Sharing, Money Purchase, SIMPLE (Savings Incentive Match Plan for Employees) IRA or a SEP (Simplified Employee Pension) IRA.

The ability to vary contribution levels.

Access to tax-free loans from savings.

Flexible distribution options for payouts.

Low-cost administration.

Before the laws changed, employers and employees together could contribute only 15 percent of employees' earnings annually to 401(k) plans on a tax-deferred basis. However, under the new rules, the owner of a sole-proprietor business can contribute 25 percent as employer, plus an additional $11,000 a year as employee - with a $40,000 cap on annual contributions.

Many qualified business owners can essentially double the amount they contribute annually, tax-deferred, to their retirement funds.

For example, the owner of an incorporated business whose annual employment compensation is $50,000 could save $12,500 tax-deferred in a Keogh Profit Sharing plan or SEP IRA, and even less in a SIMPLE IRA. However, the owner could save $23,500 in an individual 401(k). With annual employment compensation of $100,000, that same business owner could save $25,000 in a Keogh Profit Sharing plan or SEP IRA, $10,000 in a SIMPLE IRA - but $36,000 in an individual 401(k).

Business owners age 50 or older can also make "catch-up" contributions of $1,000 this year to a 401(k) plan and $500 to a SIMPLE IRA. In addition, they can roll over existing retirement accounts to consolidate their assets, then borrow against them tax free.

Naturally, financial institutions have responded to this new tax-deferred retirement investment opportunity, offering reasonable set-up fees, plus modest investment management fees. KeyBank's Victory Capital Management, for example, was one of the first investment firms to roll out an individual 401(k) plan for sole proprietors and other qualifying businesses, its new Individual(k) plan. Check with your financial institution for details on this exciting new opportunity for sole proprietors to increase their tax-deferred savings.

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