Advantages of 401(k)–Profit-Sharing Plans

By George B. Kozol

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The paramount advantage of the new design is that it allows the proprietor or owner-employee to achieve greater tax deductions than does a SEP or a SIMPLE IRA. This tax advantage exists for proprietors that have an earned income of less than $210,000. A proprietor that has an earned income of $210,000 or more can achieve the maximum deductible plan contribution with a conventional profit-sharing plan. Such an individual will be better off with a straight profit-sharing plan because this delays the decision regarding a contribution amount for a particular year until the tax due date (including extensions) for the following year. In the case of a combination 401(k)–profit-sharing plan, the 401(k) deferral allocations are made systematically throughout the year. Exhibit 1 and Exhibit 2 show the retirement contribution advantage of the single-person 401(k)–profit–sharing (PS) combination versus a SEP or a SIMPLE IRA.

The new 401(k) design is also available to a sole proprietor who employs a spouse and to one-owner corporations and LLCs that employ only the owner and spouse. The same changes to the IRC that have created the single-person 401(k) will also permit many two-person 401(k) plans covering the business owner and spouse. Exhibit 3 indicates the retirement contribution potential of a representative two-person 401(k)–profit-sharing plan versus a SEP or a SIMPLE IRA. Of course, larger deductible contributions translate to larger retirement plan accumulations, which will grow on a tax-deferred basis during a participant’s retirement years, subject to IRC minimum distribution rules, extending the tax advantages into the retirement years.

The next two financial advantages are not available with a SEP or a SIMPLE IRA: The participant in a 401(k)–profit-sharing plan can borrow from the plan, subject to certain limitations, and can use some of the accumulations to acquire life insurance.

The ability to access retirement funds via a loan can provide a business owner with a limited source of operating cash. Any funds taken from a SEP or a SIMPLE IRA are necessarily treated as a distribution taxable to the recipient, in contrast to 401(k) policy loans. In addition, if the recipient is under age 59 As at the time of distribution, an added excise tax of 10% is imposed, unless the distribution qualifies for one of several enumerated exemptions.

The third advantage, the ability to acquire life insurance, means that the proprietor can purchase life insurance using retirement plan accumulations. In this context, the life insurance protection can best be described as a preretirement survivor benefit, a benefit that is not available under any SEP or SIMPLE IRA design. The business owner with a SEP or a SIMPLE IRA must use other funds to acquire life insurance protection, unnecessarily diverting cash that could otherwise be used in business operations. Exhibit 4 illustrates the improved cash flow that can be achieved by acquiring life insurance inside a 401(k)–profit-sharing plan.

The Tax Code imposes a limit on the amount of life insurance that a qualified plan can provide for a participant. In the case of an IRC 401(k)–profit-sharing plan, the law allows a plan to use up to 25% of the allocable contributions as a premium for life insurance on behalf of the participant.

A business owner who opts for a 401(k)–profit-sharing combination can roll over SEP or SIMPLE IRA funds into the new 401(k)–profit-sharing plan. This also allows the participant to take advantage of IRS rulings that allow profit-sharing plan participants to use “aged money” without limit to acquire life insurance. In many cases, it may be possible for the business owner to use retirement funds to fund estate liquidity objectives.

The opportunity presented by owner-only 401(k)–profit-sharing plans is significant. This retirement plan design will likely supplant the SEP and the SIMPLE IRA as the retirement plan of choice for eligible business owners.