One-person 401(k) plans provide a valuable source of retirement savings for successful entrepreneurs. Given the right circumstances, such plans allow large contributions on behalf of a business owner and maintain flexibility for making contributions in future years.
For 2012, a business owner can make an elective deferral contribution of up to $17,000 (add an additional $5,500 catch-up contribution if he or she is age 50 or older at year-end) plus an employer contribution of up to 20% of self-employment (SE) income or 25% of compensation. In calculating the allowable employer contribution, the owner’s SE income or compensation is not reduced by the owner’s elective deferral contribution.
The total contributions (elective deferrals of up to $17,000, plus the employer contribution) cannot exceed the lesser of 100% of the participant’s compensation or $50,000 for 2012. Catch-up contributions to 401(k) plans of up to $5,500 in 2012 are not included in the annual additions limit.
Example: Maximizing contributions with a one-person 401(k) plan.
Kevin, age 63, is the sole owner and employee of Training Solutions, a sole proprietorship. Training Solutions is the sole source of his earned income. Kevin earns $145,000 (net of the SE tax deduction) in the current year and wishes to maximize contributions to a retirement account. He believes the business will probably continue to be profitable, but would like the flexibility of determining on a year-to-year basis how much to contribute. Kevin does not expect to hire employees and will remain a one-person company.
The following table reflects the maximum amount that Kevin can contribute to a 401(k) plan for 2012.
25% (20% for self-employed
contribution ($145,000 × 20%) $29,000
Elective 401(k) deferrals 17,000
Contributions subject to annual
addition limit 46,000
Catch-up contribution 5,500
Total contributions for 2012 $51,500
As an additional benefit, a business owner can borrow from his or her 401(k) plan if the plan document so permits. The maximum loan amount is 50% of the account balance or $50,000, whichever is less.
When the business employs someone other than just the owner, 401(k) contributions may be required for the other employees, in which case the plan would become a standard 401(k) plan with all the resulting complications. However, the plan can exclude from coverage any employee who is under age 21 and any employee who has not worked for at least 1,000 hours during any 12-month period. Because this exclusion rule allows the business owner to avoid covering young and part-time employees, the plan may still qualify as a simple and easy one-person 401(k) arrangement.
Also, if the business’s only other employees are the owner’s spouse and/or children, a 401(k) plan covering those individuals may be even more attractive than a one-person 401(k) plan, especially for owners hitting the $50,000 contribution limit.