401(K) plans for the small business owner

The 401(k) plan has become very popular among small business owners as a result of changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). These changes have made the 401(k) plan, in comparison to most other retirement plans, more beneficial and flexible for the small business owner. For the purposes of this article, we will refer to this special 401(k) plan as the " small business owner 401(k)", or SBO-401(k). A 401(k) By Any Other Name

The name assigned to the SBO-401(k) varies among financial institutions. An independent 401(k) is one of the most generic. Other examples include the "Individual(k)", "Solo 401(k)", "Uni-K Plan" and "Self-Employed 401(k)". If you are not sure which name your financial service provider uses, ask about the "401(k) plan for the small business owner." For a real-life example, see Does Vanguard have a 401(K) Plan Suitable for a Small Business?


Eligible Business Entities

Individuals who are employees of one company (in which they have no ownership) and participate in its 401(k) can also establish a SBO-401(k) for a small business they run on the side, funding it with earnings from that venture. However, their aggregate salary deferral contributions to both plans cannot collectively exceed the IRS-established annual contribution maximums (see below). Also, if their own company is operated as a corporation, contributions to the plan can be based only on the W-2 wages they receive from it. Documentation Requirements

For small business owners who meet certain requirements, most financial institutions that offer retirement plan products have developed truncated versions of the regular 401(k) plan for use by business owners who want to adopt the SBO-401(k). The result is less complex documentation used to establish the plan. For instance, a 20-page document for the regular 401(k) plan may be reduced to a three-page document for the SBO-401 (k). Make sure that you receive the proper documentation from your financial services provider. Eligibility Requirements

The SBO-401(k) plan may be adopted only by businesses in which the only employees eligible to participate in the plan are the business owners. For eligibility purposes, your spouse is considered an owner of your business. Therefore, if he or she is employed by your business and is eligible to participate in the plan, you are still eligible to adopt the SBO-401(k). If your business has non-owner employees who are eligible to participate in the plan, your business is not eligible to adopt the SBO-401(k) plan. So, you may have employees in addition to yourself and your spouse and still be eligible to adopt the plan for your business only if these other employees are not eligible to participate in the plan. The determination of whether other employees are eligible depends on the eligibility requirements you select for the plan. The requirements that you choose must remain within the following limitations:

Making the wrong elections could result in you being excluded from the plan or non-owner employees being eligible to participate in the plan. For instance, if you elect to have an age eligibility requirement of 21 even though you are only 20, you would be excluding yourself from participating in the plan. Or, say you elect zero years of service as a requirement to participate in the plan, but you have five seasonal employees who work less than 1,000 hours each year and are over age 21. These employees would be eligible to participate in the plan because they meet the age and service requirement. Consequently, their eligibility would disqualify your business from being suitable to adopt the SBO-401(k) plan. Instead, you could adopt the regular 401(k) plan.

In comparison to other popular retirement plans, the SBO-401(k) plan has high contribution limits (as outlined above), which is the key component that attracts small-business owners. Furthermore, for other retirement plans, the contributions may be limited to only employer contributions or, where salary deferral is allowed, the limit is less than that for the SBO-401(k) plan.

As mentioned earlier, you may make employee elective deferral contributions of up to 100% of your compensation, but no more than the elective deferral limit for the year ($18,500 for 2018). Profit-sharing contributions are limited to 25% of your compensation (or 20% of your modified net profit if your business is a sole proprietorship or partnership). The total SBO-401(k) contribution is the employee selective deferral contribution plus the profit-sharing contribution of up to $55,000 for 2018.

If your business is a sole proprietorship (like Jill’s business) or partnership, then the calculation gets a little more involved. In this case, your profit-sharing contribution is based on your modified net profit and is limited to 20%. For instance, in the example with Jill above, her net profit was $70,000. After making the necessary adjustments, Jill determined that her modified net profit was $65,045.65. The maximum employer contribution would therefore be $13,010.93 ($65,045.65 x 20%). Jill’s maximum contribution is $31,510.93, which is the total sum of both her $18,500 maximum salary-deferral contribution and $13,010.93 maximum profit-sharing contribution. The IRS provides a step-by-step formula for determining your modified net profit in IRS Publication 560.

No Discrimination Testing: Generally, certain nondiscrimination testing must be performed for 401(k) plans. These tests ensure that the business owners and higher paid employees do not receive an inequitably high amount of contribution when compared to lower paid employees. These tests can be very complex and may require the services of an experienced plan administrator, which can be costly. Because the SBO 401(k) plan covers only the business owner, there is no one against whom you can discriminate, so these tests are not required.

• Your business is incorporated and you earn sufficient W-2 wages to allow the maximum contribution of $51,000. The benefit of an SBO 401(k) is being able to make the maximum contribution possible. Since the dollar limit is $55,000 for 2018, adopting an SBO-401(k) is not necessary if you receive W-2 wages from your business that would allow the maximum contribution amount of $51,000 to be achieved with pure profit-sharing contributions. Of course, if you are at least age 50, adopting the SBO-401(k) would allow you to make the additional catch-up contribution of $6,000.

The SBO-401(k) plan must be established by the last day of the tax year for your business. If you operate your business on a calendar year, the deadline will be December 31. However, if your business is incorporated, you may want to establish the plan sooner in order to make salary-deferral contributions, as they must be based on current or future wages, not wages paid before the plan is established. Contribution Deadlines

Profit-sharing contributions must be made by your tax-filing deadline, including extensions. Amounts representing salary-deferral contribution must be contributed by the 7th business day of the month following the month to which the deferral applies if your business is incorporated. For instance, amounts deferred from your salary in September must be deposited to your 401(k) account by the 7th business day of October. Because salary deferral contributions cannot be based on compensation earned before you make an election, you must make your election before the first pay period by which you want to begin making salary deferral contributions.