Prior to the enactment of EGTRRA, a 401(k) plan held no benefit for an owner only business with no common-law-employees. Why? Because of elective deferrals inclusion as part of the 25% deduction limit. There was no incentive to add the complexity of elective deferrals when the maximum deduction could be achieved using a combination of a Profit Sharing and Money Purchase Plan instead. In fact, because the deductible amount was based on compensation that was “net” of deferrals, the overall deduction limit was effectively lowered!!

Now that elective deferrals are no longer included as part of the 25% deduction limit, the business owner can make greater tax deductible contributions by adding elective deferrals to a profit sharing plan design. This is especially true at income levels significantly below the $200,000 limit. 

The 401(k) advantage for the sole proprietor is enhanced by EGTRRA’s increase in the 415 annual allocation limitation from 25% of compensation (maximum annual additions of $35,000) to 100% of compensation (maximum annual additions of $40,000). By adding elective deferrals, the sole proprietor can defer the maximum elective deferral amount ($12,000 for 2003) up to 100% of compensation (provided his or her income exceeds the deferral limit). Then, the sole proprietor can put away a deductible amount of up to 25% of compensation to attain the $40,000 limit. If the sole proprietor is age 50 or over, a catch-up contribution may be made because catch-up contributions are not included in the 415 limit. Thus, the sole proprietor can exceed the $40,000 limit by the amount of the catch-up contribution for a $42,000 tax deductible contribution in 2003.

The following is an example of the drastic difference in the maximum contribution that a sole proprietor as sole employee who is age 50 or older could make in 2003 compared to 2001.To permit a concise illustration of the advantages, it is a given that the compensation shown was already reduced by half the self-employment taxes as is required for a sole proprietor and that the calculation to back into earned income (i.e. 25% to 20% and 15% to 13.043%) was already done.