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The self-employed 401(k) plan. (Employee Benefit plans).

The 2001 Tax Act (Economic Growth and Tax Relief Reconciliation Act) has made extensive changes to the rules relating to qualified retirement plans, most of which take effect in 2002. The new provisions include increased contribution and benefit limits, 401(k) elective deferral limits, deductibility limits, and compensation limits.

Increased Deductible Contributions

Prior to the Act, self-employed individuals were able to receive larger deductible contributions from less complicated, lower-cost qualified plans such as profit-sharing and money purchase pension plans. Nevertheless, the Act enables self-employed individuals, as well as corporate owners, to receive larger deductible contributions under a profit-sharing/401(k) plan.

The act permits plan sponsor to deduct employee 401(k) elective deferrals in addition to the employer contribution, effective for tax years beginning after December 31, 2001 (see the Exhibit). The Act also increases the profit-sharing/401(k) plan deduction limit for employer contributions from 15% of compensation to 25% of compensation, effective for tax years beginning after December 31, 2001. Accordingly, elective 401(k) deferral contributions are not taken into account for purposes of determining the employer contribution deduction limits, allowing self-employed individuals and corporate owners to make greater deductible 401(k) and employer contribution.

Self-employed individuals and corporate owners that have annual self-employment and W-2 income of less than $160,000 may receive greater deductible contributions under a profit-sharing/401(k) plan. Traditional profit-sharing and money purchase pension plans enable self-employed individuals or corporate owners to deduct 20% and 25% of compensation, respectively; profit-sharing/401(k) plans enable an additional 401(k) elective deferral of $11,000.

Because the maximum annual addition, and thus deductible employer contribution, is $40,000 in 20002, individuals earning $160,000 or more may receive a $40,000 deductible contribution under either a profit-sharing plan, a money purchase pension plan, or a profit-sharing/401(k) plan.

When income is less than $160,000, however, profit-sharing/401(k) plans provide dramatically greater deductible contributions, enabling self-employed individuals and corporate owners to deduct amounts greater than 25% of their compensation. For example, an individual who earns $100,000 may deduct $25,000 under either a profit-sharing plan or a money purchase plan, or they may deduct $36,000 under a profit-sharing/401(k) plan [the $25,000 employer contribution and the $11,000 401(k) contribution], for 36% of compensation. Individuals age 50 or over may deduct an additional $1,000 catch-up contribution.

Catch-up contributions. Catch-up contributions may be made by individuals age 50 and over in the amount of $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006. These amounts are additional contributions above the normal limits that apply to 401(k) plans and are not subject to the special non-discrimination tests.

Other Changes

Contribution limits. The Act gradually increases the 401(k) contribution limit from $10,500 to $15,000, beginning with a $500 increase to $11,000 in 2002. The limit then increases $1,000 for each of the next four years, to $15,000 in 2006. Furthermore, the Act increases the defined contribution annual addition limit from $35,000 in 2001 to the lesser of $40,000 or 100% of compensation in 2002. The Act increases the compensation limit from $170,000 to $200,000 in 2002, effective for qualified plan purposes. Owner-employees may receive more favorable allocations due to this increased compensation limit in determining plan benefits.

Participant loans. The Act permits 401(k) plans to make participant loans to owner-employees, including S corporation shareholders, partners, limited liability company members, and sole proprietors, effective in 2002. These self-employed individuals may now receive the same loan privileges as employees of C corporations.

Discretionary contributions. Self-employed individuals and corporate owners may make 401(k) elective deferral contributions and employer contributions at their discretion. That is, there is no annual statutory requirement to make a minimum contribution to a profit-sharing/401(K) plan.

Plan administration. Profit-sharing/401(k) plans that cover only owners and their spouses do not need to meet the discrimination tests. These plans do not need to file IRS Form 5500 (an annual report) unless the plan covers one or more common-law employees or plan assets exceed $100,000.

Rollover contributions. The Act eliminates rollover restrictions and thus enables owners to comingle funds from different types of plans and consolidate retirement assets. For example, self-employed individuals and corporate owners may roll over their 403(b) distributions and IRA accounts to a profit-sharing/401(k) plan.

Favorable Allocations

To the extent that self-employed individuals or corporate owners have employees that are eligible to participate in profit-sharing/401(k) plans, profit-sharing provisions may be designed to favorably allocate contributions for the business owner. That is, a cross-tested or new comparability allocation formula may provide significantly greater profit-sharing contribution allocations for business owners, improving employer funding for common law employees.

The 401(k) deferral contribution feature provides leverage to business owners to the extent that there is no corresponding cost to the employer for the allocation of the 401(k) deferral amount. The new comparability and age-weighted profit-sharing plan allocation formulae combine a profit-sharing plan's flexibility with a pension plan's ability to allocate benefits in favor of higher-paid employees or older employees. This flexibility creates new plan choices for plan sponsors.

New comparability plans are generally used by doctors, accounting firms, law firms, and closely held businesses that want to provide owners and management with better benefit packages than those available under traditional defined contribution plan arrangements.


Unincorporated Entities Self-employment Income (*)

                        $10,000  $50,000  $100,000  $150,000

Profit-sharing           $2,000  $10,000   $20,000   $30,000
Money purchase            2,000   10,000    20,000    30,000
Profit-sharing/401 (k)
* Under age 50           10,000   21,000    31,000    40,000
* Over age 50            10,000   22,000    32,000    41,000

(*)Net business income less one-half of self-employment tax
Incorporated Entities W-2 Income

                        $10,000  $50,000  $100,000  $150,000

Profit-sharing           $2,500  $12,500   $25,000   $37,500
Money purchase            2,500   12,500    25,000    37,500
Profit-sharing/401 (k)
* Under age 50           10,000   23,500    36,000    40,000
* Over age 50            10,000   24,500    37,000    41,000
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Article Details
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Author:Geller, Sheldon M.
Publication:The CPA Journal
Article Type:Statistical Data Included
Geographic Code:1USA
Date:Mar 1, 2002
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