Individual 401k Plans

Individual 401k Plans are retirement plans for self-employed individuals.

The claim to fame of individual 401k plans is that they offer the largest allowable contributions of all self-employed defined contribution retirement plans.

Why is this important?  Because contributions deposited into an individual 401k plan generally reduce taxable income dollar for dollar.  And when taxable income is reduced, taxes are usually reduced based upon your individual marginal tax rate.

How Much Can I Contribute to an Individual 401k?

For 2011, the individual 401k maximum contribution of $49,000 may be deferred into an individual 401k plan.  For those 50 years old and older that number increases to $54,500.  This number is essentially made up of two components:

1. Salary Deferral.  In 2011 a deferral in the amount of the lesser of 100% of compensation or $16,500 ($22,500 for 50 years old and older) is allowed.  For corporations, compensation is the W-2 amount.  For sole proprietorships, compensation equals net income less ½ of self-employment tax.
2. Profit Sharing.  For corporations, 25% of W-2 income may be deducted.  For sole-proprietorships, 20% of net income less ½ of self-employment tax may be deducted.
   

These two components, when added together, allow for the possibility of a fantastic tax-reducing opportunity.  Remember, the maximum numbers stated above are just that, maximums.  There is no requirement to contribute in any given year.

How are Individual 401k Rollovers Handled?

Traditional 401k’s, 403b’s, 457 Plans, SEP Retirement Plans and IRA’s may be rolled into Individual 401k Plans.  Conversely, individual 401k rollover options out of an individual 401k are similar to traditional 401k rollovers.  Individual 401k funds may be rolled into the above mentioned plans as permitted by the plan provider.

Can I Take an Individual 401k Loan?

Yes.  One of the most compelling features of an individual 401k plan is the loan element.  Using half of the 401k balance as collateral for a loan, the other half of the balance may be borrowed tax-free (and penalty free) from the account.  Interest at a rate of prime plus 1% is applied and generally, the loan must be paid back in five years.  

One planning tip to consider is to roll all eligible retirement plan assets into your Individual 401k plan before borrowing from your individual 401k.  This increases the balance and, therefore, maximum loan possibilities as well.

Are there Roth Individual 401k Plans?

Yes.  Remember, there are two parts to an Individual 401k Plan.  There is the salary deferral component and the profit sharing component. Participants may elect to make “after-tax” deferrals for the salary deferral component.

The salary deferral component may be either traditional or Roth, while the profit sharing component must be traditional, or “before-tax”.  

If you choose to make Roth contributions instead of traditional contributions on the salary deferral portion of your individual 401k plan, distributions may be received partially tax free upon retirement.

Let’s summarize with a few benefits and drawbacks of Individual 401k Plans.

Benefits of individual 401k plans include:

1. Highest contribution limits of any self-employed defined contribution plan.
2. Tax deferral of growth and income as long as the funds stay inside the account.
3. A Roth option allows for partial qualified tax-free withdrawals.
4. Loan provisions may allow for borrowing from an individual 401k.  A loan of half of the account balance may be made.  The remainder acts as collateral.  Interest paid goes back into the account.
5. Husband and wife may participate, even if they are both employees of the company.

Drawbacks of individual 401k plans include:

1. If the business grows to a point that it requires more employees, the individual 401k plan defaults to a conventional, more complicated 401k plan.
2. Although much simpler than a standard 401k plan, there are generally small fees associated with establishing and maintaining an individual 401k plan.
3. Because the individual 401k plan is somewhat new to the scene, there may not be as many investment choices available as with traditional IRA’s, SEP accounts, or traditional 401k’s.