‘Personal Business’ Retirement Plans
Weighing Contribution Options and Tax Implications

By Alan R. Sumutka and Brian Sootkoos

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These new, older personal business owners appear to have different savings motives. Those with immediate financial needs may be forced to save for the time when they are unable to work, while the less needy may bolster retirement accounts and garner tax benefits while achieving their business or social goals. Their optimal saving options include the following qualified plans: an “individual” traditional 401(k) plan, an “individual” Roth 401(k) plan, a profit-sharing plan (PSP), or a defined benefit plan (DBP); and the following employer-sponsored IRAs: a Simplified Employee Pension (SEP) or a Savings Incentive Match Plan for Employees (Simple).

The purposes of this article are to compare and prioritize the primary retirement plan options for personal business owners who seek to maximize contributions and tax benefits; examine the implications of ownership form (e.g., C or S corporation, sole proprietorship, or single-person limited liability company) for those options; and consider the implications if a personal business commences as a full-time venture or as a second “moonlighting” job and if a spouse or other employees are added.

“Individual” Traditional and Roth 401(k) Plans

An “individual” 401(k) plan [also known as a “solo” 401(k) plan] is a qualified defined contribution plan that is available as a traditional 401(k) or a Roth 401(k). Although established for only a single owner, either plan can accommodate an owner’s spouse, but cannot accommodate other full-time employees.

In a traditional 401(k) plan, excludable employee elective deferrals and deductible employer contributions are contributed to one account. All distributions are taxed. In a Roth 401(k), nonexcludable employee elective deferrals are made to a separate “designated Roth account.” Qualified distributions (i.e., generally from accounts held at least five years and made to a taxpayer at least age 59 Qs are tax-free. Deductible employer contributions are made to a different account and are taxed upon withdrawal. Under certain conditions, employees may be permitted to borrow from their account.

Contributions and benefits. For either plan, contributions are discretionary and limits are the same. In 2007, employee elective deferrals are limited to $15,500 plus $5,000 in catch-up contributions for individuals age 50 or older. Employer contributions are restricted to the lesser of $45,000 or 25% of employee compensation (up to $225,000 per employee). The overall limit on annual additions is the lesser of $45,000 or 100% of compensation.

As illustrated in Exhibit 1, a corporate owner/employee (of a C or S corporation) under age 50 with a gross salary of $100,000 can make a $15,500 employee elective deferral and the employer can contribute/deduct $25,000 (25% of $100,000) for a total contribution of $40,500, which is within the overall $45,000 limit. If age 50 or older, the employer/employee contributions increase to $45,500 ($40,500 plus the $5,000 catch-up contribution). Catch-up contributions are ignored in the overall $45,000 limit.

For a self-employed owner, the limitations on “employee” elective deferrals and “employer” contributions are the same as for a corporate owner/employee. Compensation in this context, however, means earned income. For employer contribution/deduction limitations, earned income is calculated as the net profit from the business (generally, the Schedule C profit) minus the deductions for one-half of the self-employment tax paid and the contribution made on behalf of the self-employed individual. Therefore, although the limit on the employer’s deduction is 25% of employee compensation, the limit for a self-employed owner effectively is 20% [employer percentage/(1 + employer percentage)] of the net business profit minus one-half of the self-employment tax paid, because the employer’s contribution reduces compensation.

As illustrated in Exhibit 2, a noncorporate owner (i.e., an owner of a sole proprietorship or single-person LLC) under age 50 with net business profit of $100,000 can make a $15,500 employee elective deferral and the employer can contribute/deduct $18,587 [20% of $92,935 ($100,000 net business profit minus one-half of self-employment tax paid of $7,065)], for a total contribution of $34,087. If 50 or older, the employer/employee contribution amounts to $39,087 ($34,087 plus the $5,000 catch-up contribution). All future examples relate to the results illustrated in Exhibits 1 and 2, which assume employee elective deferrals are maximized.

A 401(k) provides the best opportunity to maximize contributions with the least amount of compensation. With only $25,000 in gross salary, a corporate owner can shelter $21,750, and a self-employed owner with $25,000 in net business profit can shelter $20,147, which is larger than any contribution to a non-401(k) plan at these income levels. Similarly, an owner can shelter the maximum $45,000 at $125,000 in salary ($175,000 in net business profit), the lowest compensation level among all alternatives.

Alternative results. If an owner establishes a personal business while employed elsewhere (i.e., moonlighting in a personal business) and participates in another plan that accepts employee elective deferrals, the limitation on the deferrals for all plans is $15,500 annually (plus $5,000 in catch-up contributions). For example, consider a moonlighting owner who makes $8,000 in elective deferrals into a 403(b) plan at a full-time job. The maximum elective deferral to a 401(k) plan is $7,500 ($15,500 – $8,000). If the owner desires a Roth 401(k) without losing the employer match at the full-time job, the owner can reduce the 403(b) elective deferral to equal the employer match (e.g., $6,000) and fund a personal business Roth 401(k) with elective deferrals of $9,500 ($15,500 – $6,000). If a moonlighting owner owns a second business that sponsors a defined contribution plan, the aggregate contributions to all plans cannot exceed $45,000.

Either kind of 401(k) plan can accommodate a working spouse. Optimally, a spouse who participates in a 401(k) plan can increase a family’s tax benefits when the owner’s compensation exceeds the amount necessary to fund the $45,000 contribution limit. For example, if a corporate owner’s gross salary is $118,000, the maximum benefit is $45,000 [elective deferral of $15,500 plus employer contribution of $29,500 (25% of $118,000)]. If the owner’s gross salary was $148,000, the maximum benefit is still $45,000. However, if the owner’s spouse earns $30,000 in gross salary (and reduces the owner’s salary to $118,000), the spouse can shelter $23,000 [elective deferral of $15,500 plus employer contribution of $7,500 (25% of $30,000)], for a total family contribution and tax benefit of $68,000. If 50 or older, each individual could increase their elective deferral by $5,000, resulting in a total family contribution of $78,000. Clearly, the added benefits outweigh any additional payroll taxes from spousal employment.

Even if an owner’s salary does not exceed $118,000 (i.e., the amount needed to fund the $45,000 maximum contribution), spousal participation can increase family benefits. As detailed above, if a spouse earns $30,000 in salary, the spouse can shelter $23,000. If the spouse’s salary reduces the owner’s salary to $88,000 ($118,000 -- $30,000), the owner’s maximum benefit is $37,500 [elective deferral of $15,500 plus employer contribution of $22,000 (25% of $88,000)], for a total family contribution of $60,500. Although the family contribution is less than under the optimal solution (i.e., $68,000), it is $15,500 more (i.e., the spouse’s elective deferral) than if only the owner was employed.

Employing a spouse provides other potential benefits to a self-employed owner. If all employees (i.e., the spouse) are included in a medical reimbursement plan that offers family coverage (i.e., includes the owner), the business/family potentially increases deductions for health insurance and other medical expenses which are unavailable to a nonemployee owner. Of course, a corporate owner (i.e., employee) can establish such a reimbursement plan without spousal employment.

By definition, a personal business has no employees. If a nonspouse employee is hired, an individual 401(k) must be converted to a nonindividual 401(k) plan, include any eligible employee [generally 21 or older with one year of service (i.e., has worked 1,000 hours in 12 consecutive months, which permits an employer to exclude employees by limiting employment)], and satisfy other coverage and nondiscrimination requirements. If a plan provides for immediate 100% vesting, the service requirement can be increased to two years. The resulting cost increase may lead personal business owners to consider a less expensive alternative.

Administrative issues. Although a prototype traditional 401(k) plan is available from brokerage firms, no-load mutual fund companies, and other financial firms, only a few firms (e.g., T. Rowe Price) offer a prototype Roth 401(k). A 401(k) must be established and employee elective deferrals made by the year-end of the business. Employer contributions are due by the due date of the business return, including extensions. Within seven months of year-end, annual Form 5500 EZ (for owner/spouse–only plan with assets of less than $100,000) or Form 5500 (if assets exceed $250,000) is due.

Traditional or Roth 401(k)? Because the contribution limits are identical, participants in either form of 401(k) plan can shelter the same total contributions. However, a traditional 401(k) plan exploits current tax benefits (i.e., excluded elective deferrals), but a Roth 401(k) plan promises future tax-free income (i.e., excluded distributions).

Because there are no modified adjusted gross income phase-out limits (as in a Roth IRA), a Roth 401(k) affords high-income individuals an opportunity to gain Roth benefits. The Roth component favors taxpayers who expect to be in a higher tax bracket in retirement than at the time of contribution. Often overlooked is the effect that unneeded but required minimum distributions (RMD) have on a retiree’s tax bracket at age 70 Qs .

The tax-free Roth component provides a hedge against future tax rate increases, and the taxable portion provides tax diversification if rates fall. By generating taxable and tax-free income, a Roth 401(k) “smooths income” to maintain a stable tax bracket unless unneeded Roth RMDs trigger higher taxes. To avoid RMD, the Roth component can be rolled over to a Roth IRA. Although this strategy creates a new five-year waiting period before tax-free withdrawals can begin, rollovers to an existing Roth IRA (with its own waiting period) often avoid or lessen the new waiting period. Roth IRAs offer a superior wealth transfer advantage because the elimination of RMD increases the amount available for a future tax-free Roth “stretch IRA” for younger beneficiaries. Of course, if Congress alters the tax status of Roth IRAs or the tax system itself (e.g., to a flat or consumption tax), these benefits may disappear.

Simplified Employee Pensions and Profit-Sharing Plans

Although an SEP is an employer-sponsored IRA that does not permit employee borrowing and a PSP is a qualified plan that permits borrowing, they are comparable vehicles. Both are defined contribution plans, funded only by discretionary, deductible employer contributions; the withdrawals are taxable. They can accommodate an owner, owner’s spouse, and other employees.

Contributions and benefits. The employer contribution limits are the same for either plan, and the same as for a 401(k) plan. In 2007, deductible employer contributions are limited to the lesser of $45,000 or 25% of compensation (for the self-employed, it is 20% of net profit minus one-half of self-employment taxes paid). The overall limit on annual additions is $45,000 or 100% of compensation (up to $225,000 per employee). Employee elective deferrals are not permitted.

For example, the maximum contribution/deduction, regardless of age, for a corporate owner with a gross salary of $100,000 is $25,000 (25% of $100,000) and for a noncorporate owner with net business profit of $100,000 is $18,587 [20% of $92,935 ($100,000 net business profit, minus one-half of self-employment tax paid of $7,065)]. Both results are within the overall $45,000 contribution limit.

Because SEPs and PSPs cannot accept employee elective deferrals, their total contributions pale in comparison to 401(k) plans. For example, a corporate owner under age 50 reaches the maximum $45,000 contribution level at about $200,000 of salary; a 401(k) owner reaches the same level at about $125,000 of salary. Nevertheless, SEPs and PSPs provide a greater sheltering opportunity than Simples at all but lower income levels (as discussed below).

Alternative results. Similar to a 401(k) plan, if a moonlighting owner owns a second business that sponsors a defined contribution plan, the aggregate contributions to all plans cannot exceed $45,000. The overall elective deferral limit is irrelevant absent such contributions.

Including a working spouse increases a family’s retirement benefits only when the owner’s compensation is greater than the amount needed to fund the maximum $45,000 contribution limit. For example, if a corporate owner’s gross salary is $180,000, the maximum benefit is $45,000 (25% of $180,000). If the owner’s gross salary is $210,000, the maximum benefit remains $45,000. If a spouse earns $30,000 in gross salary (and reduces the owner’s salary to $180,000), the spouse shelters $7,500 (25% of $30,000), for a total family contribution of $52,500. This family contribution, however, is less than the $67,500 amount available under a 401(k) plan at the same compensation levels.

Because neither plan accepts elective deferrals, adding a spousal employee when an owner’s compensation does not exceed the amount needed to fund the maximum $45,000 contribution limit merely shifts the employer’s contribution from the owner to the spouse, and adds to family/business payroll taxes if the owner’s salary exceeds various federal or state payroll tax wage bases (e.g., $97,500 for Social Security in 2007). A self-employed owner must weigh the additional costs against other potential benefits of spousal employment (e.g., a medical reimbursement plan).

In a PSP, an employer can ensure that an employee fails the eligibility requirements by limiting employment to less than 1,000 hours. An employer cannot use this strategy with an SEP because it must cover any employee age 21 or older, performed any service in the current year and in three of the past five years, and earns at least $500 in the current year. In other words, although an SEP can exclude a new employee for the first two years of employment, this same fate applies to the owner and/or owner’s spouse. Otherwise, an employee who earns at least $500 must be covered in the first year.

Administrative issues. Using a readily available prototype plan, establishing either plan is relatively simple. However, a PSP must be established earlier [i.e., by the end of the tax year, versus the due date of the employer’s return (including extensions) for an SEP]. Contributions to either plan are due by the due date of the employer’s return (including extensions). An SEP has no reporting requirements, whereas a PSP must file an annual IRS Form 5500 EZ or Form 5500 within seven months of the year-end.

SEP or PSP? Because the contribution limits are the same, the salient differences between these two options lie in administrative and nonspouse employee coverage issues. Usually SEPs are easier to administer, but PSPs offer a greater opportunity to restrict employee eligibility. Thus, an SEP is generally a better choice when no employees are anticipated, or if a worker’s employment cannot be limited to less than 1,000 hours annually.

Savings Incentive Match Plan for Employees

A Simple IRA is a defined contribution plan that can accommodate a single owner, a spouse, and other employees, but does not permit employee borrowing. Excludable employee elective deferrals (technically called salary reduction contributions) and mandatory deductible employer contributions are made to one account. All distributions are taxed.

Contributions and benefits. Employee elective deferrals must be determined as a percentage of compensation (not as a fixed amount), and in 2007 are limited to $10,500 plus $2,500 in catch-up contributions for those age 50 and over. Deductible employer matching contributions cannot exceed 3% of employee compensation (up to $225,000). For example, a corporate owner under the age of 50 with a gross salary of $100,000 can make a $10,500 employee elective deferral and the employer can contribute/deduct $3,000 (3% of $100,000), for a total contribution of $13,500. If 50 or older, the owner/employee contribution increases to $16,000 ($13,500 plus $2,500 catch-up contribution).

For a self-employed owner, the employer compensation base is calculated as net business profit less a constant 7.65% “deemed deduction,” which represents an artificial determination of the employer’s deductible portion of self-employment taxes. (In calculations for the aforementioned plans, net business profit is reduced by one-half of the self-employment tax paid.) For example, a noncorporate owner under age 50 with net business profit of $100,000 can make a $10,500 employee elective deferral and contribute/deduct an employer match of $2,771 [3% of $92,350 ($100,000 net business profit minus a deemed deduction of $7,650)], for a total contribution of $13,271. If 50 or older, the owner/employee’s contribution increases to $15,771 ($13,271 plus $2,500 catch-up contribution).

Although a Simple never provides the maximum contribution opportunities of a 401(k) plan, it provides greater benefits than an SEP or PSP at some lower income levels, making it attractive to such owners. For example, a corporate owner under age 50 with a gross salary of $25,000 can make a combined employer/employee contribution of $11,250, as compared to an SEP or PSP amount of only $6,250. If 50 or older, a Simple owner/employee’s contributions at salaries of $25,000 and $50,000 are $13,750 and $14,500, respectively, which exceeds the $6,250 and $12,500 contributions to an SEP or PSP, respectively. Similar favorable results occur for a self-employed owner under age 50 at $50,000 in net business profit and for those age 50 or older at $75,000 in net business profit.

Alternative results. A moonlighting owner who participates in another plan which accepts employee elective deferrals faces the same limitation as those who participate in an individual 401(k). Because the aggregate elective deferral maximum is $15,500, a moonlighter might have to reduce elective deferrals to one of the plans.

As with other plans, under certain circumstances employing one’s spouse can increase family benefits. For example, if a corporate owner’s gross salary is $100,000, the maximum benefit is $13,500 [elective deferral of $10,500 plus employer contribution of $3,000 (3% of $100,000)]. If a spouse earns $50,000 in gross salary (which reduces the owner’s salary to $50,000), each spouse shelters $12,000 [elective deferral of $10,500 plus employer contribution of $1,500 (3% of $50,000)], for a total family contribution of $24,000. This $13,500 increase is caused primarily by a second $10,500 spousal elective deferral. If both individuals are 50 or older, the total family contribution increases to $29,000 ($24,000 plus $5,000 catch-up contributions). In either instance, the increased spousal benefits exceed the cost of increased payroll taxes due to spousal employment.

If a nonspouse employee is hired, a Simple must cover any employee, regardless of age, who earned at least $5,000 during any two preceding calendar years and is reasonably expected to receive at least $5,000 during the current calendar year. Because the 3% employer contribution is a matching contribution, employer contributions are not required for an employee who fails to contribute. Because a Simple is not subject to nondiscrimination rules, the owner or owner’s spouse can contribute to their accounts and receive the employer match. Similarly, if an employee’s elective deferral is minimal, the employer’s matching contribution is modest [e.g., if nonspouse employee salary is $50,000, employer contribution is only $1,500 (3% of $50,000)]. A Simple contribution made in lieu of an annual bonus would reduce payroll taxes and other salary-related benefit costs.

The employer matching contribution can be reduced to as low as 1%, but only for two years during a five-year period. Alternatively, in lieu of matching contributions, the employer can elect to make a 2% nonelective contribution for each employee who earns at least $5,000 during the year. Any rate reduction, however, would also penalize the owner.

A Simple, with contributions predicated upon employee elective deferrals and relatively low employer contribution rates, may be the least expensive plan for an employer who cannot restrict worker employment to less than 1,000 hours annually.

Administrative issues. A Simple must be maintained on a calendar-year basis. It is available if the employer had 100 or fewer employees who received $5,000 or more in compensation in the preceding year. It can be established by completing Form 5304-SIMPLE (if contributions will be deposited in various employee-selected financial institutions) or Form 5305-SIMPLE (if all contributions will be deposited at one financial institution). The plan must be set up by October 1 or soon thereafter for a new employer coming into existence after October 1. At least 60 days prior to each year, an employer must provide participants with written notification of the intended contribution for the upcoming year. The last day to make employee elective deferral contributions is 30 days after the end of the month for which the contributions are made. Employer contributions must be made by the due date of the employer’s tax return (including extensions). A Simple has no reporting requirements (e.g., Form 5500). Prototype plans are available from many financial institutions.

Defined Benefit Plans

Under certain circumstances, a DBP provides the highest contributions and benefits. Because they are determined actuarially and are taxpayer-specific, this article highlights the primary issues relevant to a personal business owner.

A DBP is a qualified retirement plan that provides a determinable retirement benefit to plan participants, usually for life, that often is expressed in the form of a formula (e.g., years of service divided by current age times highest three consecutive years of compensation). Deductible employer contributions fund the anticipated benefits based on actuarial assumptions such as age, annual compensation, anticipated annual benefit, normal retirement age, and interest rate. In 2007, employer contributions are permitted to fund an annual benefit that does not exceed the lesser of $180,000 or 100% of the participant’s average compensation for the highest three consecutive years.

DBPs are most beneficial to older owners (typically over age 50) with high incomes. Their few remaining years of service often translate into contributions in excess of the annual $45,000 contribution limit of a 401(k) plan. By offering a separate DBP and a separate 401(k) plan, contributions and tax benefits can be enhanced. Because annual contributions are mandatory and generally must be made for at least five years (or else the plan may be disqualified), significant precontribution profits are necessary. All distributions are taxed, and under certain conditions employees can borrow from the plan.

Alternative results. Unless a moonlighting employee earns significant compensation, a DBP may not be useful. Employing a spouse can increase family contributions substantially [i.e., from DBP contributions and employee elective deferrals in a companion 401(k) plan], far in excess of any additional payroll taxes resulting from spousal employment. For the reasons cited above, older employees require greater funding than younger employees, but generally a DBP must follow the same eligibility and nondiscrimination rules as other qualified plans.

Administrative issues. A DBP is the most costly and complicated form of plan to administer. Usually a benefits services company prepares a plan document, an actuary calculates annual additions, a money management firm invests assets, and an accountant or benefits company files the annual IRS Form 5500. The plan must be established by the end of the tax year and contributions made by the due date of the business tax return (including extensions).

©2008 The New York State Society of CPAs. Legal Notices