A 401(k) Plan for Self-Employed Individuals

Dear Readers,
This week, I wanted to tell you about a new type of 401(k) plan that is just available for self-employed individuals -- there are around 13 million self-employed individuals in the U.S., so I'm sure this affects a lot of you!

Dear Gail -

I used to work as head chef in a well-known restaurant in Chicago. You'd know the name if I mentioned it. I liked the pay and the retirement plan, but six years ago I got tired of the commute and the politics (yeah, even in the restaurant industry) and quit.

Now I run a catering business out of our home. Business is booming. Right now I'm the only employee, except for my husband who puts in about 10 hours a week helping with deliveries. Once the kids are in school full-time, I'll probably look into hiring some help, but at this point I'm not interested in getting too big.

Here's my question: We're essentially banking the money I make with my catering (about $100,000 a year), but income taxes are eating us alive. My financial advisor says I could save a boat-load if I started a 401(k) for myself. Is this possible? I thought only big companies could have 401(k)s.

Thanks,

Mattie

Dear Mattie -

That's one smart financial advisor you have! Up until now, the retirement plan options for a one-person business like yours were pretty limited. But in the past year or so it's become possible for the self-employed individual to enjoy all the benefits of a 401(k)/profit-sharing plan -- a tax deduction for the company, up to $40,000 a year set aside for your own retirement, personal loans, etc.-- without the red tape and reporting hassles.

First, a bit of history. The first retirement plans created for small businesses were Keogh plans. They've been around for decades and have gone through a number of changes over the years. But essentially a Keogh allows your company to make a contribution -- usually to a "profit-sharing plan" -- on your behalf. Your company gets to deduct this amount, so it reduces the amount of taxes it pays. Since the maximum it can deduct is 25 percent of your gross salary, you could sock away $25,000.

In the late 1980s, in an effort to encourage small businesses to offer retirement benefits to their workers, Congress introduced "SEPs", which stands for "Simplified Employee Pension." As the name implies, these are easy to set up and can be used whether there is one employee (the owner) or up to 25. Essentially, the company opens IRA accounts for all workers who qualify and makes an annual contributions to these based on a percentage of their salary. SEPs eliminate most of the red tape associated with standard pension plans and 401(k)s -- which had been the main reason small employers said they didn't offer a retirement plan.

But because of perceived drawbacks, small business owners did not exactly rush to offer SEPs. For one thing, the same percentage -- up to 25%, but not more than $40,000 -- has to be contributed for EVERY employee who qualifies. Let's say the owner of the firm makes $80,000 and two other employees each earn $30,000. If the owner wants to make a 10% contribution to her own SEP account ($8,000), then she's got to contribute $3,000 to the account of each employee. (There is a provision which allows the employer to subtract the amount the company paid into Social Security on behalf of an employee.)

Under a SEP, the contribution percentage is flexible and can change each year. If profits are up, a company might increase the percentage; if it's been a lean year, the contribution could be skipped entirely.

But the lack of a "vesting" provision is what makes a lot of business owners balk: unlike bigger plans, there is no waiting period with a SEP. An employee does not have to work for the company for a certain number of years before the money becomes his. A SEP contribution becomes the property of the employee the minute it is made. If he wants, he can quit the next day and take his account balance with him. In other words, SEPs do nothing to encourage employee loyalty.

Furthermore, once your company has more than 25 employees (including the business owner), you can no longer continue contributing a SEP. You've got to freeze it and open another type of retirement plan.

"SIMPLE" plans, which were introduced in the 1990s, were aimed at addressing this. "SIMPLE" is an acronym for "Savings Incentive Match Plan." This type of small business retirement plan can accommodate up to 100 employees, so they make more sense for growing companies.

Another difference is that a SIMPLE plan allows employees to make contributions to their own accounts -- that's the "Savings" part of the name. This year the maximum contribution an employee can make is $7,000. Thanks to the Economic Growth and Tax Relief Reconciliation Act passed in 2001, this amount will increase until it hits $10,000 by 2005.

The "Incentive Match" comes from the employer who MUST make a contribution every single year. The only choice is whether the mandatory employer contribution will be a fixed 2% of every employee's pay or a matching contribution of 3% of employees' own contributions each year. Another drawback for the business owner, who typically earns more than her employees, is that compared to a SEP or Keogh, the total amount contributed each year to a SIMPLE plan -- company + worker contributions -- generally ends up being less.

In your case, if you contributed $7,000 as the "employee" and 3% as the "employer," the most you could put into your account is $10,000, which would be $15,000 less than under either a Keogh or SEP.

Since a SIMPLE plan also uses IRAs for employee accounts, like a SEP, there is no vesting; an employee can withdraw the money from his account whenever he wants.

Enter the "Individual 401(k)" which, in my opinion, provides the ideal solution for some 13 million self-employed small business owners who are looking for a way to reduce their taxable income and maximize their retirement savings.

First, let me clear up some confusion. No matter what size the company, contributions to a 401(K) account can only be made by the employee herself -- not the company. Under the 2001 Tax Act, the amount an employee can contribute rose to $11,000 this year. This amount increases each year until it hits $15,000 in 2006. If you're over age 50, you can contribute an extra $1,000 each year to your 401(k) this year, and more in future years.

(Note that while these higher contributions are allowed by federal law, they are neither automatic nor mandatory. States can and do set their own contribution limits. In addition, it's up to each company to decide if it wants to allow employees to contribute at a higher rate. If it does, it has to vote to amend the legal document which governs the plan. )

If a company that offers a 401(k) wants to make contributions to a retirement account on behalf of its workers, it must establish parallel but separate accounts. Often this takes the form of a "profit-sharing" plan. The Tax Act also significantly increased the percentage of salary a company can contribute. It's now 25%.

By coupling an "individual" 401(k) with a profit-sharing plan, a one-person business could set as much as $40,000 a year aside for the owner! Make that $41,000 if they're over age 50. And compared to a SEP or Keogh, you can max out the contribution at a much lower salary because of the fact that the employee also gets to kick in money.

The single-person 401(k) works for anyone who is self-employed, regardless of the legal form of their business. It can be a sole proprietorship, a partnership, or a corporation. You can be the butcher, the baker, the candlestick-maker, an attorney, CPA, plumber, doctor, architect or independent contractor.

If you want, you can choose to allow plan participants (you!) to take out a personal loan from their account -- something not allowed under any of the other types of plans. There's also "vesting." Once you add employees you could require that they work for you for a certain number of years before they own the right to the money your company contributes to their profit-sharing account.

But not all "individual" 401(k)s are alike. Most have to be closed the minute you hire another employee. Thanks to a special provision of the law, this does not include your spouse, provided, as in your case, he only works part-time for your company. And he can also participate in the plan. But hire anyone else and you'll probably need to start from scratch.

So look for an individual 401(k) that can grow as your company does. And thank your financial advisor for being on top of things!

Best wishes,

Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.