Are You Still Using SEP IRAs?
Jason Washo, CPA, PFS
The 2001 Tax Act created an opportunity for owner only businesses to increase contributions to retirement plans. The Tax Act makes individual 401(k) plans an attractive alternative to SEP IRAs. The individual 401(k) is a profit-sharing plan and 401(k) combined. A self-employed business owner, with no employees, can add salary deferral to their profit-sharing contributions for large tax deductions they can keep! If you have clients with owner-only businesses such as realtors, attorneys, architects, doctors, consultants, and accountants; you may be able to offer them a solution that increases their tax deduction and helps them reach their retirement goals faster.
The individual 401(k) goes by many names, including solo 401(k), employer-only 401(k), single participant 401(k) and mini 401(k). It can be used by small businesses where the only employees are the owners and their spouses. A client who has one or more part-time employees, who work fewer than 1,000 hours a year, can utilize an individual 401(k).
Contribution limits for a SEP IRA vs. an individual 401(k) for an unincorporated self-employed business owner:
Net ProfitSEP-IRAIndividual 401(k)Ind.401(k) w/Catch-up
$25,000$4,647$18,587$20,651*
$50,000$9,294$23,294$27,294
$75,000$13,940$27,940$31,940
$100,000$18,616$32,616$36,616
$150,000$28,482$42,000$46,000
$210,000$40,322$42,000$46,000
* At lower levels of compensation, the maximum contribution can be found by reducing the profit sharing percentage and maximizing salary deferral amounts.
Contribution limits for a SEP IRA vs. an individual 401(k) for an incorporated business (including S-Corp):
W-2 WagesSEP-IRAIndividual 401(k)Ind. 401(k) w/Catch-up
$25,000$6,250$20,250$24,250
$50,000$12,500$26,500$30,500
$75,000$18,750$32,750$36,750
$100,000$25,000$39,000$43,000
$150,000$37,500$42,000$46,000
$210,000$42,000$42,000$46,000
Salary deferral spices up individual 401(k)s and gives your clients larger tax deductions. The participant can defer up to $14,000 of salary in 2005. If the participant is 50 years or older, they can add a “catch-up” contribution of $4,000 in 2005. The 2001 Tax Act also increased the profit sharing contribution from 15% to 25% allowing for larger contributions to qualified plans. The deferred amounts do not count toward the 25% profit sharing contribution. The maximum compensation used in these calculations is $210,000 for 2005. The maximum amount that can be received in the form of combined deferrals and employer contributions is the lesser of 100% of compensation or $42,000. The catch-up contribution is exempt from this limit, increasing a 50+ participant’s maximum contribution to $46,000.
Salary deferrals should be funded in a timely manner. Deposit contributions no later than the 15thday of the month following the month in which they were deferred.
There are some reasons you would want to avoid using an individual 401(k):
• Plans must be established prior to the business’ year end.
• It is not suitable for business owners considering hiring employees in the near future.
• Incorporated businesses and S-Corporations must use W-2 wages to calculate the contribution and deferral amounts.
• The Tax Act of 2001 expires after 2010 unless extended by Congress.
• Administration and set-up costs will be slightly higher than a SEP IRA.
• Some plans may not offer the owner many investment choices.
Having to file form 5500, Annual Return/Report of Employee Benefit Plan, is often cited as a reason to avoid using an individual 401(k). Generally these plans can be reported using 5500 EZ, if at all. An entity is exempt from filing 5500 EZ if the total plan assets have been at or below $100,000 beginning on or after January 1, 1994. The plan must satisfy minimum coverage requirements as defined in 410(b), can not cover a business that is a member of a “controlled group,” and can not cover a business for which leased employees (as defined in section 414(n)(2)) perform services. Any plan meeting these requirements and exceeding $100,000 in total plan assets would be required to file 5500 EZ.
There are some compelling reasons to have an individual 401(k):
For most self-employed individuals with less than $170,000 of compensation, the individual 401(k) allows for much larger tax deductible contributions. As with other qualified plans, the earnings grow tax deferred and all contributions are tax deductible. The plans available today offer a wide variety of investment choices including money markets, CD’s, bonds, stocks, mutual funds, unit investment trusts, and much more. Loan provisions are also attractive for business owners who often worry about losing access to their money.
The individual 401(k) offers borrowing flexibility not commonly found in SEP IRAs. Some clients are more willing to contribute to retirement plans when they can access their money in case of emergencies. The participant can generally take up to one-half of the vested account balance as a loan thus avoiding early withdrawal penalties and income taxes. This is limited to a maximum of $50,000 and the terms of the loan are subject to special Internal Revenue Service regulations.
The flexibility of contributions is attractive for the self-employed business owner. The participant can vary contributions and reduce contributions to zero if needed. If a business owner has a fluctuating income, this could be an important feature to consider.
The Employee Retirement Income Security Act of 1974 (ERISA) generally requires a fidelity bond for qualified plans. A plan fiduciary and any person who handles plan assets normally must be bonded. Adding to the advantages of individual 401(k)s, ERISA bonding is not required.
Most individual 401(k)s will accept rollovers from old 401(k)s, transfers from SEP IRAs, and traditional IRAs. Try to avoid taking advantage of this feature. Rolling assets into this plan may accelerate the necessity to file 5500 EZ. If total plan assets are less than $100,000, and all other qualifications are met, 5500 EZ does not need to be filed. If necessary, roll all other plans into a Traditional IRA and keep these funds separate from the 401(k).
Advisors should consider if clients would benefit from an individual 401(k). The SEP IRA is still appropriate for clients who are happy with lower deductions and are on target to reach retirement savings goals. Clients may be in higher income situations, which allow for maximum contributions under the SEP IRA. If the advantages of the individual 401(k) outweigh the drawbacks and your client is hungry for tax deductions they can keep, the individual 401(k) may be the solution.
Jason E. Washo, CPA/PFS, is President of Washo Financial, LLC. He can be reached at jason@washofinancial. com or 480-223-1315.
