Many companies talk about 401K plans…whether the plans are full-fledged company plans (with employees) or individual plans. In fact, many of these plans are touted as perfect for the self-employed individual, and they may be. But remember one thing — just because a plan is “solo”, “uni” or “one-participant”, doesn’t necessarily mean that you have the freedom to control your plan in the manner you may desire.
None of the aforementioned designations indicate you can truly control how you invest your funds. They’re merely 401K plans for self-employed individuals. What you really need to ask yourself…and there is not necessarily a wrong answer….is: 1) Do I only want to invest in stocks, bonds and mutual funds, etc. as part of my plan? OR 2) Do I want to have the option to invest in any asset class not prohibited by the IRS? Folks, there is no wrong answer….that’s what makes this country great…you have options and choices. But, I am guessing if you are a regular reader of this site, your preference is probably not to be limited in your investment options.
But, self-directed or not, all 401K plans for self-employed individuals must meet certain requirements. Let’s review some of the basics:
1) “Is this new?” – I hear this all the time and, no, 401K plan for individuals are not new. Nor, by the way, is your ability to self-direct an individual plan…again, as long as you follow all IRS and, if applicable, Department of Labor regulations.
2) Participants – An individual plan covers a business owner with no employees, or that person and his/her spouse. Please note, individual plans (generally) have the same requirements of any other 401K plan.
3) Contributions – One interesting facet of an individual 401K plan is that the owner is both the owner and employee as it relates to the plan. Contributions can be made by both elective deferrals and employer non-elective contributions. For 2011, elective deferrals can be made up to 100% of compensation (i.e., earned income) up to an annual contribution limit of $16,500 (under the age of 50) or $22,000 (over the age of 50), or
a. Employer Non-Elective Contributions up to 25% of compensation as defined by the plan, or total contributions, not counting “catch up” contributions, cannot exceed $49,000.
You will always want to review with your CPA the exact, maximum contribution you can make. If you are wanting to maximize your contributions (up to $49,000), you must make a special computation to figure that amount for both elective deferrals and non-elective contributions you can make for yourself. When figuring this contribution amount, compensation is your “earned income” which is defined as net earnings from self-employment after deducting both: 1) one-half of your self-employment tax, and 2) contributions to yourself.
Let’s use an example. Let’s say that Sam is 52 and earned $50,000 from self-employment earnings. He deferred $16,500 in regular elective deferrals plus the $5,500 in catch-up contributions…totaling $22,000. His business contributed 25% of his compensation to the plan….or $12,500. Total contributions to his plan for 2011 total $34,500. This is the maximum that can be contributed to the plan for Sam for 2011.
Testing in a one-participant plan – A business owner with no employees (other than possibly a spouse) does not need to perform non-discrimination testing for the plan as there are no employees in which to discriminate against. However, if the business owner hires even just one employee, you can throw everything out the window. If employees are hired and they meet the eligibility requirements of the plan, they must be included in the plan and their elective deferrals will be subject to annual compliance testing, etc. This doesn’t mean that when a self-employed individual has a 401K plan…and, let’s say it is self-directed as well….and adds employees that he cannot self-direct or have the plan. It just means that there will be new and different requirements as it relates to annual testing.
Also, keep in mind that under current regulations, if an individual plan has assets of under $250,000, there is no reporting requirement for the plan until assets either surpass $250,000 or the plan is in its last year of being a plan. Once surpassing $250,000, the plan can have its assets reported via the 5500EZ form or 5500-SF form.
As always, this piece is to be educational in nature. What’s important to keep in mind is that you always have options…make sure you know them….it is your money, your plan and your future. Specifically, as it relates to contributions made to the plan…..and you know what I am about to say is coming…you should always review annual contributions to your plan with your tax or accounting professional.