Maximizing Tax Savings with Owner - Only 401(k)

Until recently, owners of businesses with no employees found that the contribution limits, administration costs and compliance requirements of a 401(k) retirement plan made other options like Simplified Employee Pension (SEP) plans, SIMPLE IRAs (Savings Incentive Match Plan for Employees) or a Keogh look much better by comparison. That may no longer be true. The Owner-Only 401(k) – with simplified reporting requirements and contribution limits that in some cases are more than double those of SEPs, SIMPLEs or Keoghs – has become an excellent vehicle for sole proprietors to save substantial amounts of pre-tax dollars for retirement.

An Owner-Only 401(k) can be a smart idea for individuals who work as independent contractors and want to defer taxes on as much of their income as possible. Two types of contributions can be made to this kind of 401(k). As a business owner, you can make tax-deductible annual profit-sharing contributions of up to 25% of compensation, however, this amount is reduced to 20% of your net earnings if you are a sole proprietor. In addition, you can make up to $14,000 of salary deferral contributions annually. And if you’re 50 or older, you may be eligible to make an additional catch-up contribution of $4,000. The maximum total contribution you can make is the lesser of $42,000 ($46,000 if you’re 50 or older) or 100% of compensation.

Higher contributions

For example, consider a sole proprietor who operates his own technology consulting company and reports self-employment income¹ of $100,000 annually, taxed on his personal return at his highest marginal rate when he files his IRS Form 1040. With the Owner-Only 401(k), he is able to defer taxes on $34,000 of that income, a $14,000 employee salary deferral contribution and $20,000 employer profit sharing contribution, resulting in a savings of more than $7,000 on taxes.² With a SEP plan, he could make an annual employer contribution of $20,000, or 20% of his compensation. With a SIMPLE IRA, he would be limited to just $13,000 in combined salary-deferral ($9,000) and matching employer contributions ($4,000).

Weighing the options

Owner-Only 401(k) plans are designed to cover only the owner and his or her spouse. But if your business is expanding and you plan to add employees in the near future, you would need to convert the plan to a traditional 401(k), meaning more rigorous reporting requirements, including the annual filing of IRS Form 5500 and having to pass nondiscrimination tests, which could limit the contributions made by highly compensated employees. (Note that an Owner-Only 401(k) plan must file Form 5500 when assets of the plan exceed $100,000.)

Also, the Owner-Only 401(k) is best suited for business owners with self-employment income¹ below $210,000. Someone earning a steady $210,000 a year, for example, could obtain the same benefits available under an Owner-Only 401(k) with a SEP plan, which is less complicated and less costly to administer. Additionally, SEP plans don't require an IRS Form 5500 or have annual program administration fees. 

¹ Net business income minus half of self-employment tax.

² Based on 2004 IRS Tables. Represents an unincorporated, self-employed, married individual with two dependent children, filing jointly. The individual earns $100,000 and the spouse has no earned income.