401k Plans for a Small Business Owner

Contributing to a 401k plan has become ever more easier for small business owners as a result of new legislation brought about by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The EGTRRA has made 401k plans more flexible, easy and beneficial for a small business owner. First, a small business 401k is also known by its other names; Individual(K), Solo 401k, or Self Employed 401(k). Another common misrepresentation of small business 401k plans is that only sole proprietors can open them. This is incorrect; infact partnerships & corporations can also opt for a small business 401k provided they are owned by eligible plan participants.

Eligibility

Small Business 401k plans can be set up by businesses whose only eligible employees to participate in 401k plans are the small business owners themselves. For eligibility purposes, a spouse is also considered a small business owner and if employed by your business, is also eligible to participate in a small business 401k.

If your business has non-owner employees (employees who do not have any interest or shares in the business), then your small business is NOT eligible to participate in a small business 401k. What’s more, if you have employees other than you and your spouse, you can still set up a small business 401k plan provided your employees are not eligible to participate in the plan. How do you know if your employees are not eligible to participate in your small business 401k? By the eligibility requirements selected for the plan. Here they are:

Age: You can choose to exclude employees who are under 21 years of age.

Years of Service: You can require an employee to perform atleast 1 year of work service before he/she becomes eligible to make salary deferral 401k contributions. You could also require your employees to perform atleast 2 years of service* before being eligible to participate in profit-sharing contributions.

* For eligibility purposes, an employee has done 1 year of service if he/she has worked atleast 1000 hours during the year. Most small business 401k plans set the 1000 hours as the minimum required work service before employees become eligible to contribute to Small Business 401k plans.

Be Careful When Making the Elections

When choosing the eligibility requirements of your small business 401k, be especially careful not to exclude yourself from the plan. For example if you set an age eligibility requirement of 25 years while you are only 22, you are excluding yourself from your business plan. Also, if you set the minimum required work term as 0 years, you could make your part time employees (employees who work less than 1000 hours a year) eligible for your small business 401k and remember, if these employees become eligible for your small business 401k, your plan becomes void!

Small Business 401k Contributions

There are 2 types of contributions for small business 401k’s. They are salary deferral and profit-sharing contributions.

i) Salary-Deferral: Salary Deferral contributions can be up to 100% of your compensation income; no more than the salary-deferral limit for the year (which is $15,000 for 2006 and $15,500 for 2007).

ii) Profit-Sharing: Your business may contribute up to 25% of your business net income (20% of your modified net profit for unincorporated businesses; with a limit of $44,000 for 2006 and $45,000 for 2007.

Combined salary-deferral & profit-sharing contributions cannot exceed $44,000 for 2006 and $45,000 for 2007. Also, if you reach 50 by year-end, you can contribute an additional $5000 for 2005 and 2006.

Comparison with Other Small Business 401k Plans

In comparison with other small business 401k plans, this SBO 401k has very high contribution limits which is why so many small business owners are attracted to it. Here is a comparison of contributions limits for various types of small business 401k plans.

Type Salary Deferral Contribution Limit Maximum Employer Matched Contribution Catch Up Contributions
Small Business 401k $15,000 for 2006 and $15,500 for 2007 25% of Compensation or 20% of net profit for unincorporated businesses $5000 for 2006/2007
SEP IRA Not permitted 25% of Compensation or 20% of net profit for unincorporated businesses Not permitted
Profit Sharing Not permitted 25% of Compensation or 20% of net profit for unincorporated businesses Not permitted
Simple IRA $10,000 for 2006 and $10,500 for 2007 3% of compensation $2500 for 2006/2007

Illustration

John is a small businessman and earned $85,000 net income for 2006. John wants to set up a retirement plan for his business and would like to maximize his 401k contributions. The following table outlines the maximum contributions John can make towards each type of small business 401k.

Type Salary Deferral Maximum Employer Matched Contribution Total
Small Business 401k $15,000 $17,000 $32,000
SEP IRA $0 $17,000 $17,000
Profit Sharing $0 $17,000 $17,000
Simple IRA $10,000 $2550 $12,550

Benefits of the Small Business 401k

i) Loans – You can borrow from your Small business 401k plan either 50% of your plan balance or $50,000, whichever is lesser.

ii) Form 5500 – You are not required to file Form 5500 unless your small business 401k balance runs over $100,000.

iii) No Discrimination testing – Certain non-discrimination testing is usually done on all 401k plans. These tests ensure that higher paid employees do not receive more contributions & deductions on their taxes than lower paid employees. These tests are comprehensive and consume a lot of time, as well as require the services of an experienced plan administrator. Since small business 401ks cover only the business owners, there is no one the business owner can discriminate against, and thus is exempt from non discrimination testing.

iv) Tax Deductions – The Small business 401k allows you to deduct plan contributions of up to 25% of your eligible compensation. For plan purposes, total compensation is limited to $220,000 for 2006 and $225,000 for 2007. Any amounts earned in excess of $225,000 are disregarded for plan purposes.

When Small Business 401k is Not Suitable For You

i) When you have employees other than business owners who are eligible to participate in the plan

ii) When your total compensation is sufficient enough to allow you to contribute the $44,000/$45,000 as profit sharing contributions rather than salary deferral contributions. If your business is incorporated and you earn wages of $176,000 or more, you can make profit-sharing contributions and maximize them @ $44,000. However if you are 50 years or over, a small business 401k will be more suitable because it will allow you to make an additional $5000 for catch-up contributions.

Deadlines

Your small business 401k plan must be established by the last day of the fiscal tax year for your business. For example if your year-end is December 31st, then your small business 401k must be established by that date.

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