Going It Alone

GRAND RAPIDS — Putting away $98,000 a year in tax-deferred savings sounds pretty appealing, but it also sounds impossible. Even with contribution levels for IRAs and other tax-sheltered retirement savings arrangements escalating in recent years, most individuals get “capped out” in the low tens of thousands.

For small business owners, it’s often more difficult because of additional limits on tax-deferred profit sharing. However, recent changes in tax laws have given some small business owners a distinct edge in saving for retirement.

Under the previous laws, small business owners had to lump together all the sources for their tax-deferred savings, subject to a relatively low contribution cap, namely $30,000.

“It was not practical to combine a 401(k) and a profit-sharing plan, because 401(k) deferrals reduced the amount that you could contribute to a profit-sharing plan, and you could get to the maximum with just the profit-sharing plan,” said Brian Moore, a financial and trust adviser with Legacy Trust, a Grand Rapids wealth management firm. “So small-business owners didn’t have the opportunity to defer like you and I might. This change decoupled that. It now says you can defer and have a profit-sharing plan.”

As such, there is suddenly a new market for business owners who previously had no incentive to start a 401(k) plan, as opposed to participating in other tax-deferred plans such as SEPs and SIMPLEs, or just using traditional IRAs.

“The challenge there is, you hit the maximums much quicker,” Moore said.

Changes in the Internal Revenue Code starting in 2002 increased the maximum amount of a business owner’s compensation that could be contributed to a profit-sharing plan and deducted from taxable income from 15 to 25 percent. At the same time, because of the “decoupling” Moore mentioned, it is now possible to contribute that 25 percent maximum through a profit-sharing arrangement and contribute other funds up to increased 401(k) maximum contribution levels. For individuals under the age of 50, the total contributions for 2006 can be no higher than $44,000. For those 50 and above, the limit is $49,000. In a “mom and pop” business, each spouse can make the maximum contributions, with a combined possible total of $98,000.

Of course, the number of people who are able to set aside nearly $100,000 each year for retirement is quite small. That does not mean that a solo 401(k) is not a good choice for lower-income business owners. Moore said that part of the beauty of the individual 401(k) is its flexibility, especially for individuals that own businesses as sole proprietorships or partnerships.

“Your salary isn’t assumed paid until the end of the year. Even if you’re taking those regular draws from the business, those are not necessarily considered paid salary until the end of the year when you know what your profit is,” he said.

In a poor year, a solo 401(k) participant could contribute nothing. In a good year, the business owner could contribute up to the maximum. The true flexibility comes in being able to wait until the year is over to make that decision.

“So you could take a big lump sum and plop it into the plan at that point. You don’t really have to pre-plan as long as you get your plan in place by Dec. 31,” Moore said. Technically, the deadline is the end of the tax year, so depending on what fiscal schedule is used, the date may vary. Contributions to the 401(k) must be made by the due date for filing income taxes, usually April 15.

The rules are slightly different for corporations. For incorporated business owners, the contributions would be more formal and regular, like those made in traditional 401(k)s in larger corporations, and there is no ability to wait until the end of the year to determine contributions.

Although the rules regarding solo 401(k)s are different from a taxation standpoint, the actual investments are the same as traditional 401(k) funds. Moore said that Legacy Trust uses Fidelity Investments to manage the funds. Individual 401(k) owners have the same interactivity and level of control that investors with traditional 401(k)s enjoy.

The idea of an individual 401(k) might seem too good to be true. That’s not the case, but they are not necessarily right — or available — for everyone. To qualify for a solo 401(k), a business can’t have any common-law employees that qualify for the plan. That still allows the owner and the owner’s spouse to participate. The business can have other employees, but there are certain restrictions they must meet in order to be considered ineligible for participation.

Moore said that he has seen a rising interest in these retirement plans among a new breed of business owner. In some cases, these are people who have a side business in addition to a regular job. In other cases, they are people who are retired or semi-retired, and are continuing to work for themselves.

“People are saying, ‘I am going to take these skills that I have accumulated during my primary working years — and those are very valuable to a lot of people — (and) I am going to take those and use them on my own terms. I can still make a lot of money. So I am not only going to fund my retirement during the early years of my career; I’m going to continue to stash money away, but I’m going to have the flexibility of doing it on my own terms.’”