Link to special CCH Tax Briefings on key topics from 2003:
 

• Year-End Tax Legislation Update (Dec. 10)
• Corporate Income Tax and 'Bonus' Depreciation
  (Dec. 4)
• Military Family Tax Relief Act (Nov. 11)
• Jobs and Growth Tax Relief Reconciliation Act of 2003 (May 28)

CCH can assist you with stories, including interviews with CCH subject experts. Also, the CCH Whole Ball of Tax 2004 is available in print. Please contact:
 
Leslie Bonacum
(847) 267-7153
mediahelp@cch.com
 
Neil Allen
(847) 267-2179
allenn@cch.com

2004 Planning

One-Person 401(k) Plans Offer New Retirement Planning Option

(RIVERWOODS, ILL., January 2004) – As part of their retirement planning this year, small business owners may want to consider the increasingly popular option of a one-person 401(k) plan, according to CCH INCORPORATED, a leading provider of pension and tax law information and software. Changes enacted under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) have made it advantageous for small business owners with no employees, other than a spouse, to set up a 401(k) plan. These plans, also referred to as solo 401(k) or individual 401(k) plans, allow a sole owner to make greater tax-deferred and tax-deductible contributions than are permitted under SEP or SIMPLE plans, without facing the complex nondiscrimination testing associated with large 401(k) plans.

"The individual 401(k) plan can provide sole owners with the ability to contribute more money on a tax-deferred basis towards retirement," noted CCH Senior Pension Law Analyst Nicholas Kaster, J.D. "Careful planning is needed, however, and there are some areas where sole owners should have caution as they consider setting up these arrangements."

Recent Changes Make Solos More Attractive

While nothing legally prevented sole owners from setting up their own 401(k) plans prior to EGTRRA, the contribution and deduction limits in effect were not sufficient to induce sole owners to pursue this option, given the relatively simple and low-cost alternatives of the SIMPLE IRA and SEP.

Three significant changes enacted under EGTRRA combined to make the one-person 401(k) an attractive option: the increased elective deferral limits, increased overall defined contribution plan limits and changes to plan deduction limits.

• Increased elective deferral limit: Prior to EGTRRA, elective deferral limits for 401(k) plans were set at $7,000, then indexed to inflation in $500 increments. The limit was $10,500 for 2001. EGTRRA increased the statutory limit on elective deferrals to $11,000 in 2002, with increases in $1,000 annual increments until the limit reaches $15,000 in 2006. For the 2003 tax year, the elective deferral limit is $12,000. For the 2004 tax year, the limit is $13,000. After 2006, the $15,000 limit is indexed for inflation in $500 increments.

In addition, EGTRRA introduced the concept of catch-up contributions to 401(k) plans. Individuals who reach age 50 before the end of the tax year are generally permitted to make additional elective deferrals in the amount of $2,000 for the 2003 tax year, $3,000 for the 2004 tax year, $4,000 for the 2005 tax year and $5,000 for tax years beginning in 2006 and later. The $5,000 limit that applies in 2006 is indexed to inflation in $500 increments beginning in 2007.

So, a sole owner who is at least 50 years old (or will attain age 50 in 2004) can defer a maximum of $16,000 (the $13,000 regular elective deferral plus the $3,000 catch-up contribution) to a 401(k) plan. A sole owner may make this additional deferral for a year even before reaching age 50, as long as he reaches age 50 by the end of the year.

• Increased defined contribution limits: Since a 401(k) plan is typically a part of a profit-sharing plan, it is subject to the defined contribution plan limits set under the Internal Revenue Code. Prior to the enactment of EGTRRA, the limit on the annual additions to a defined contribution plan was set at the lesser of 25 percent of compensation or $35,000. EGTRRA increased the statutory dollar limit to $40,000. This amount is indexed in $1,000 increments. Moreover, the 25 percent-of-compensation limit was increased to 100 percent of compensation.

Thus, in the 2004 tax year, the defined contribution plan limit is the lesser of $41,000 or 100 percent of compensation. It should be noted that catch-up contributions are not taken into account in applying the Code limit. For a catch-up eligible participant, the overall limit on contributions to a defined contribution plan is $44,000 in 2004 (the $41,000 limit plus the $3,000 catch-up limit).

• Changes to plan deduction limits: Prior to EGTRRA, deductions for employer contributions to profit-sharing plans were limited to 15 percent of compensation. As a result, the deductible limit for a profit-sharing contribution in 2001 for a participant earning $100,000 was $15,000. This restriction caused employers to adopt combination profit-sharing and money purchase plans, which allowed for employer contributions of up to 25 percent of employee compensation. EGTRRA increased the profit-sharing plan deduction limit to 25 percent of compensation and allowed employers to maximize deductible contributions under a stand-alone profit-sharing plan. Thus, under the modified limit, the deductible profit-sharing contribution for an individual earning $100,000 in 2004 would be $25,000.

Moreover, EGTRRA provided that 401(k) plan elective deferrals are not subject to the deduction limit. A sole business owner may contribute and deduct 25 percent of compensation as a contribution to a 401(k) plan without regard to the amount of elective deferrals made to the plan.

As a result of the EGTRRA contribution and deduction limit increases, an owner-participant with sufficient income may make annual elective deferrals as an employee up to the maximum permitted in 2004 – $13,000 or $16,000 if the participant is age 50 or older – and may make and deduct contributions as an employer of up 25 percent of compensation without violating the overall defined contribution plan limits.

This can be illustrated by the following example: Fred Allen, age 55, is the sole owner of ABC, Inc. His compensation is $100,000 in 2004. He establishes a one-person 401(k) plan. In 2004, he can make an "employer" profit-sharing contribution of $25,000 (25-percent of compensation, which is the maximum deductible amount) and he can make an "employee" elective deferral contribution of $13,000. In addition, because he is over 50, he can make an additional $3,000 catch-up contribution. Thus, the maximum permissible contribution is $41,000. This compares favorably to the amount he could contribute under a SEP or SIMPLE plan. Under a SEP, Fred would be limited to a $25,000 contribution (25 percent of compensation). SEPs do not allow for catch-up contributions. Under a SIMPLE IRA, Fred would be limited to a $13,500 contribution, consisting of a $9,000 deferral (the maximum 2004 deferral amount allowed for SIMPLE plans), a $3,000 match (a 3 percent employer match), and a $1,500 catch-up contribution (the maximum allowed for SIMPLE plans in 2004).

Distributions and Elective Deferrals

As with other profit-sharing or pension arrangements, contributions to 401(k) plans are not taxed when they are made to the plan. Instead, taxation is deferred until amounts from the plan are distributed to the participant. In addition, similar to traditional IRAs, SEPs and SIMPLE plans, amounts in 401(k) plans, including one-person 401(k) plans, are subject to required minimum distribution rules and to the premature withdrawal penalty.

Elective deferrals held in a 401(k) plan generally may not be distributed prior to a stipulated event, such as death, disability, hardship, retirement or severance from employment. Hardship distributions are permitted where the participant has an immediate and heavy financial need and other resources are not reasonably available to meet that need.

However, many 401(k) plans contain a provision that allows participants to borrow against their account balances prior to the occurrence of a distributable event.

"Such a provision can be made a part of a one-person 401(k) plan and thereby provide the owner-employee with a way to access funds in the account," Kaster explained. "However, the Internal Revenue Code imposes restrictions on plan loans to ensure they are true loans and not disguised distributions."

These restrictions are:

1. The loan must be evidenced by a legally enforceable agreement that specifies the amount of the loan, the term of the loan and the repayment schedule. It must also bear a reasonable rate of interest.

2. The loan amount cannot exceed the lesser of $50,000 (reduced by any previous outstanding loans) or the greater of one-half of the present value of the participant’s nonforfeitable accrued benefit under the plan or $10,000.

3. The loan must be repaid within five years, except for a loan that is used for the acquisition of a dwelling unit that will be used as the principal residence of the participant within a reasonable time. (Refinancings do not generally qualify as principal residence loans.)

4. The loan must be amortized on a substantially level basis and payments must be made no less frequently than quarterly over the term of the loan.

Loans that do not meet the above requirements are considered deemed distributions and subject to current income tax. In addition, if the participant has not attained age 59½ or is not otherwise entitled to an early distribution, the 10-percent additional tax on early distributions will be assessed.

Rollovers

EGTRRA liberalized the rollover rules for post-2001 distributions. Now, an eligible rollover distribution from a traditional (but not a Roth) IRA, 403(b) annuity or 457 plan can be rolled over tax-free to a 401(k) plan.

"This expanded portability allows a business owner with a one-person 401(k) plan to roll over assets from other retirement plans that she may have accumulated and thereby consolidate retirement holdings in the one-person 401(k) plan," Kaster explained. "This could be particularly useful if she chooses to adopt a loan feature in the 401(k) plan. IRA-based retirement vehicles, such as the SEP-IRA or SIMPLE IRA, prohibit plan loans," he added.

Trust Requirement

The assets of a one-person 401(k) plan must be held in a written trust. This is a requirement imposed on tax-qualified plans. The regulations specify that the trust must be created or organized in the United States and must be maintained at all times as a domestic trust in the United States. Typically, the financial institutions setting up such plans offer standardized plan and trust documents.

Annual Filing Requirements

401(k) plans are required to file Form 5500 (Annual Return/Report of Employee Benefit Plan) annually with the Employee Benefits Security Administration (EBSA).

As an alternative to the Form 5500, which can be burdensome, one-person 401(k) plans may file a streamlined Form 5500-EZ (Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan). Moreover, plans with assets of $100,000 or less are not required to even file the Form 5500-EZ, except in the final plan year.

"To be able to file the Form 5500-EZ, the plan for which the form is being filed must cover only the individual and his or her spouse who owns the entire business, whether or not incorporated," Kaster explained. "Further, the plan may not cover a business that is a member of an affiliated service group, a controlled group of corporations or a group of businesses under common control."

As noted, a one-person 401(k) plan that has total plan assets of $100,000 or less at the end of the plan year is not required to file a Form 5500-EZ, or any Form 5500. Plans holding assets of more than $100,000 at the end of the plan year must file Form 5500-EZ for the year in which the assets exceeded $100,000 and for each succeeding year, even if total plan assets are reduced to $100,000 or less. So, if an individual has a 401(k) plan with assets of $110,000 at the end of the 2002 plan year, makes a distribution which reduces the assets to $90,000 at the end of the 2003 plan year, the individual would still be required to file a Form 5500-EZ for the 2003 plan year and all following years.

"There is one catch," Kaster said. "A Form 5500-EZ must be filed in the final plan year of a one-person 401(k) plan even if the total assets of the plan have always been less than $100,000. The final plan year is the year in which the distribution of all plan assets is completed."

Some Cautionary Notes

"While the one-person 401(k) plan offers relatively greater tax-deferral potential than the SEP or SIMPLE plan, it is not for everyone," Kaster noted.

For instance, a one-person 401(k) plan could not be fully utilized by an individual who is covered by an employer 401(k) plan and who moonlights as a consultant or independent contractor. The reason is that the elective deferral limits apply to individual plan participants and not to the plan. Thus, an individual under age 50 is not entitled to defer more than $13,000 in the 2004 tax year, regardless of how many plans he or she participates in.

Also, because a one-person 401(k) plan is a qualified plan, it could be more expensive to establish and maintain than a SEP or SIMPLE IRA, due to the annual filing and trust requirements. The addition of a plan loan feature could add even more expense to the plan.

"These added expenses would have to be weighed against the increased contribution limits provided by a one-person 401(k) plan," Kaster said.

Finally, a sole owner who contemplates adding employees should think twice about adopting a 401(k) plan. Once non-highly compensated employees are added, the plan becomes subject to burdensome and complex (and expensive) nondiscrimination testing. Plans with only highly compensated employees are deemed to satisfy the applicable nondiscrimination tests. However, employers who maintain plans that also cover non-highly compensated employees may need to make additional matching or nonelective contributions in order for the plan to pass nondiscrimination testing and maintain its qualified status.

Impact of EGTRRA's Sunset Provisions

As the tax law changes that provided the impetus for the one-person 401(k) plan were enacted under EGTRRA, they also are subject to its peculiar sunset provisions. These provisions, which were added to comply with congressional budget rules, provide that all changes made by EGTRRA will not apply to tax or plan years beginning after December 31, 2010. This means that all provisions, including those impacting pensions and employee benefits, will expire after 2010, unless extended by subsequent legislation.

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served more than four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, accounting, legal, securities and small business markets. CCH is a Wolters Kluwer company. The CCH Federal and State Tax group, CCH Tax Compliance and Aspen Publishers Tax and Accounting group comprise the new Wolters Kluwer Tax and Accounting unit. The unit’s web site can be accessed at tax.cchgroup.com.

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