Have Your 401(k)ake and Eat It Too

Sole Proprietor 401(k) — The Plan of 2009
Rev. 02/21/03, E-mail Alert 2003-3, Rev. 11/11/08, Rev. 07/23/09, Email-Alert 2009-11

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!!

Since 2002, elective deferrals have not been included as part of the 25% deduction limit, thus, 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 $245,000 limit.

The 401(k) advantage for the sole proprietor (or one person plan) 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 up to a maximum of $40,000 as increased by COLA which for 2009 is $49,000. By adding elective deferrals, the sole proprietor can defer the maximum elective deferral amount ($16,500 for 2009) 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 $49,000 limit. If the sole proprietor is age 50 or over, a catch-up contribution of $5,500 for 2009 may be contributed as catch-up contributions are not included in the 415 limit. Thus, the sole proprietor can exceed the $49,000 Section 415 limit by $5,500 for a total of contribution $54,500, all tax deductible for 2009.

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 2009 compared to 2001.To permit a concise illustration of the advantages, our example treats as a given the fact that the compensation shown was already reduced by half the self-employment taxes as is required for a sole proprietor and that the calculation of net profits into earned income has already been handled (for examples 25% to 20% or 15% to 13.043%).

Bill Grossman, QPA