401(k) Plans For The Small Business Owner

The 401(k) plan has become very popular among small business owners as a result of changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). These changes have made the 401(k) plan, in comparison to most other retirement plans, more beneficial and flexible for the small business owner. For the purposes of this article, we will refer to this special 401(k) plan as the "small business owner 401(k)", or SBO-401(k).

Tutorial: Retirement Planning

A 401(k) By Any Other Name …
The name assigned to the SBO-401(k) varies among financial institutions. Some examples include the "Individual(k)", "Solo 401(k)", "Uni-K Plan" and "Self-Employed 401(k)". If you are not sure which name your financial service provider uses, ask about the "401(k) plan for the small business owner".

Eligible Business Entities
A common misconception about the SBO-401(k) is that it can be adopted only by sole proprietors. The SBO 401(k) plan, however, may be adopted by any small business, including corporations and partnerships, provided that the only eligible plan participants are the business owners.

Documentation Requirements
For small business owners who meet certain requirements, most financial institutions that offer retirement plan products have developed truncated versions of the regular 401(k) plan for use by business owners who want to adopt the SBO-401(k). The result is less complex documentation used to establish the plan. For instance, a 20-page document for the regular 401(k) plan may be reduced to a three-page document for the SBO-401 (k). Make sure that you receive the proper documentation from your financial services provider.

Eligibility Requirements
The SBO-401(k) plan may be adopted only by businesses in which the only employees eligible to participate in the plan are the business owners. For eligibility purposes, your spouse is considered an owner of your business. Therefore, if he or she is employed by your business and is eligible to participate in the plan, you are still eligible to adopt the SBO-401(k). If your business has non-owner employees who are eligible to participate in the plan, your business is not eligible to adopt the SBO-401(k) plan. So, you may have employees in addition to yourself and your spouse and still be eligible to adopt the plan for your business only if these other employees are not eligible to participate in the plan. The determination of whether other employees are eligible depends on the eligibility requirements you select for the plan. The requirements that you choose must remain within the following limitations:

  • Age: You may choose to exclude employees who are under age 21.
    • Years of Service:
      • For 401(k) Salary-Deferral Contributions: You may require an employee to perform one year of service before he or she becomes eligible to make salary-deferral contributions.
        • For Profit-Sharing Contributions: You may require an employee to perform up to two years of service in order to be eligible to receive profit-sharing contributions. However, most SBO-401(k) plans limit this requirement to one year.

      For plan purposes, an employee is considered to have performed one year of service if he or she works at least 1,000 hours during the year. While you may generally choose to require fewer than 1,000 hours under a regular qualified plan, most SBO-401(k) plans include a hard-coded limit of 1,000 hours.

      When determining eligibility requirements for your plan, you may also exclude non-resident aliens who receive no U.S. income and/or those who receive benefits under a collective bargaining agreement.

      Exercise Caution with Elections
      Making the wrong elections could result in you being excluded from the plan or non-owner employees being eligible to participate in the plan. For instance, if you elect to have an age eligibility requirement of 21 even though you are only 20, you would be excluding yourself from participating in the plan. Or, say you elect zero years of service as a requirement to participate in the plan, but you have five seasonal employees who work less than 1,000 hours each year and are over age 21. These employees would be eligible to participate in the plan because they meet the age and service requirement. Consequently, their eligibility would disqualify your business from being suitable to adopt the SBO-401(k) plan. Instead, you could adopt the regular 401(k) plan.

      Check Plan Document Provisions
      Some SBO-401(k) products, by definition, require further exclusion. Before you decide to establish an SBO-401(k) plan, be sure to check with your financial services provider regarding the provisions of the plan.

      SBO 401(k) Plan Components
      There are two components to the SBO 401(k) plan: salary-deferral contributions and profit-sharing contributions.

      • Salary Deferral: You may make a salary-deferral contribution of up to 100% of your compensation/income, but no more than the salary-deferral limit for the year, which is $17,500 for 2013.
        • Profit-Sharing Contribution: The business may contribute up to 25% of your compensation (20% of your modified net profit for unincorporated businesses), but no more than $51,000 for 2013.

        The combined salary-deferral and profit-sharing contributions must not exceed $51,000 for 2013. However, if you reach age 50 by year-end, you may contribute an additional $5,500 for catch-up contributions as salary deferrals.

        SBO Contributions Vs. Other Plans
        In comparison to other popular retirement plans, the SBO-401(k) plan has high contribution limits (as outlined above), which is the key component that attracts small-business owners. Furthermore, for other retirement plans, the contributions may be limited to only employer contributions or, where salary deferral is allowed, the limit is less than that for the SBO-401(k) plan.

        The following is a summary of contribution comparisons for the popular employer plans used by small businesses:

        Account Salary Deferral Maximum Employer Contribution Catch-Up Contribution
        SBO-401(k) $17,500 (for 2013) 25% of compensation or 20% of modified net profit for unincorporated business owners $5,500
        SEP IRA Not Allowed 25% of compensation or 20% of modified net profit for unincorporated business owners Not Allowed
        Profit Sharing or Money Purchase Pension Plan Not Allowed 25% of compensation or 20% of modified net profit for unincorporated business owners Not Allowed
        SIMPLE IRA $12,000 (for 2013) 3% of compensation/income $2,500

        (To learn more about SIMPLE plans, see Introduction To SIMPLE 401(k) Plans, SIMPLE IRA Vs SIMPLE 401(k) Plans and Plans The Small Employer Can Establish.)

        Let's use an example to illustrate:

        Suppose that Jill, a sole proprietor who is under age 50, has a net profit of $70,000. Jill wants to adopt a retirement plan for her business, and would prefer to adopt the plan that allows the highest contribution limit. The following table outlines the approximate maximum Jill would be able to contribute with each plan for 2013:

        Account Salary Deferral Maximum Employer Contribution Total
        SBO-401(k) 17,500 $13,010.93 $30,510.93
        SEP IRA $-0- $13,010.93 $13,010.93
        Profit-Sharing or Money Purchase Pension Plan $-0- $13,010.93 $13,010.93
        SIMPLE IRA $12,000 $1,939.35 $13,939.35
        The Calculation
        As mentioned earlier, you may make salary-deferral contributions of up to 100% of your compensation, but no more than the salary-deferral limit for the year ($17,500 for 2013). Profit-sharing contributions are limited to 25% of your compensation (or 20% of your modified net profit if your business is a sole proprietorship or partnership). The total SBO-401(k) contribution is the salary-deferral contribution plus the profit-sharing contribution of up to $51,000 for 2013.
        If your business is a corporation, the profit-sharing contribution is based on W-2 wages you receive. For instance, if you receive $70,000 in W-2 wages, your profit-sharing contribution could be up to $17,500 ($70,000 x 25%). When added to your salary-deferral contribution of $17,500, this would be $35,000.
        If your business is a sole proprietorship (like Jill\'s business) or partnership, then the calculation gets a little more involved. In this case, your profit-sharing contribution is based on your modified net profit and is limited to 20%. For instance, in the example with Jill above, her net profit was $70,000. After making the necessary adjustments, Jill determined that her modified net profit was $65,045.65. The maximum employer contribution would therefore be $13,010.93 ($65,045.65 x 20%). Jill\'s maximum contribution is $29,510.93, which is the total sum of both her $16,500 maximum salary-deferral contribution and $13,010.93 maximum profit-sharing contribution. The IRS provides a step-by-step formula for determining your modified net profit in IRS Publication 560.

        Other Benefits of the SBO 401(k)

        • Loans: Like other qualified plans, you can borrow from the SBO 401(k) up to either 50% of your plan balance or $50,000, whichever is less. Check the plan document to determine if any other limitations apply. (For more on this, read Borrowing From Your Plan and 8 Reasons To Never Borrow From Your 401(k).)
          • 5500 Filing May Not Be Required: Because the plan covers only the business owner, you may not be required to file Form 5500 series return unless your balance exceeds $250,000.
            • No Discrimination Testing: Generally, certain nondiscrimination testing must be performed for 401(k) plans. These tests ensure that the business owners and higher paid employees do not receive an inequitably high amount of contribution when compared to lower paid employees. These tests can be very complex and may require the services of an experienced plan administrator, which can be costly. Because the SBO 401(k) plan covers only the business owner, there is no one against whom you can discriminate, so these tests are not required.
              • Deducting Contributions: Similar to other employer plans, the SBO 401(k) allows you to deduct plan contributions of up to 25% of eligible compensation. For plan purposes, compensation is limited to $255,000 for 2013. Earnings of more than that amount is disregarded for plan purposes.

              When the SBO 401(k) Is Not Suitable for You
              The SBO is not suitable under the following circumstances:

              • You have employees other than business owners who are eligible to participate in the plan.
                • Your compensation is sufficient to allow you to contribute the $51,000 as profit-sharing contributions.
                  • Your business is incorporated and you earn sufficient W-2 wages to allow the maximum contribution of $51,000. The benefit of an SBO 401(k) is being able to make the maximum contribution possible. Since the dollar limit is $51,000 for 2013, adopting an SBO-401(k) is not necessary if you receive W-2 wages  from your business that would allow the maximum contribution amount of $51,000 to be achieved with pure profit-sharing contributions. Of course, if you are at least age 50, adopting the SBO-401(k) would allow you to make the additional catch-up contribution of $5,500.

                  Deadline to Establish the SBO-401(k)
                  The SBO-401(k) plan must be established by the last day of the tax year for your business. If you operate your business on a calendar year, the deadline will be December 31. However, if your business is incorporated, you may want to establish the plan sooner in order to make salary-deferral contributions, as they must be based on current or future wages, not wages paid before the plan is established.

                  Contribution Deadlines
                  Profit-sharing contributions must be made by your tax-filing deadline, including extensions. Amounts representing salary-deferral contribution must be contributed by the 7th business day of the month following the month to which the deferral applies if your business is incorporated. For instance, amounts deferred from your salary in September must be deposited to your 401(k) account by the 7th business day of October. Because salary deferral contributions cannot be based on compensation earned before you make an election, you must make your election before the first pay period by which you want to begin making salary deferral contributions.

                  For unincorporated businesses, your salary-deferral contributions may be deposited by your tax-filing deadline, including extensions. However, you salary deferral election, including the amount you plan to defer, must be made by the last day of your tax year.

                  Other Considerations
                  If you own more than one business, you must check with your tax professional to determine whether you are eligible to adopt the SBO-401(k) - ownership in another business that covers employees other than the business owner could result in you being ineligible for this type of plan.