Why Business Owners are Turning to Owner-Owned 401(k) Plans

An owner-only 401(k) plan is an approach to blend the tax advantages of an employer-sponsored retirement plan with pre-tax personal retirement savings.

A Financially-Independent Retirement

According to a recent Social Security Administration study, most adults over 55 are not financially independent during their retirement years.

  • 34.0% of retirees have incomes under $20,000
  • 26.5% of retirees have incomes between $20,000 – $40,000
  • 20.7% of retirees have incomes between $40,000 – $75,000
  • Only 18.8% of retirees have incomes in excess of $75,000

These percentages mean that more than 6 out of 10 retirees have an income less than $40,000 per year.  The secret to retiring in the top 20% and gain financial independence is committing to a retirement plan while a person is working and earning an income.  Using a portion of this income to save for the future financial security that is craved by every retiree is necessary to achieve this attainable goal.

Retirement Income Sources

For many small business owners, concern centers around the most effective way to secure a comfortable retirement for their future.  Once these hard-working men and women are done growing their business and ready to retire, their retirement income will be subject to three primary sources:

  • Social Security Income – In 2018, according to the Social Security Administration, the average retired worker will receive around $1,404 per month in Social Security benefits.  This amount is around 40% of their pre-retirement income. However, as this pre-retirement income amount increases, the percentage that is replaced by Social Security goes down.
  • Employer-Sponsored Plans and IRAs – Pensions and employer-sponsored retirement plans are available for many workers.  However, the most popular retirement plan offered by most employers are Individual Retirement Accounts (IRAs).  These plans allow individuals to contribute to an IRA in order to supplement pension and Social Security benefits.
  • Home Ownership and Personal Retirement – The gap that exists between retirement income that a person expects to receive and what they will collect from Social Security

An Owner-Only 401(k) Plan

An owner-only business employs only the owner and a spouse.  Available for 20+ years, the traditional 401(k) plan allows American workers to save money for retirement on a tax-advantaged basis.  In 2002, the traditional 401(k) plans took a turn and become an attractive choice for an owner-only business.

A 401(k) plan allows pre-tax elective salary deferred contributions that are made by employees and is essentially a profit-sharing plan.  For a business owner, a tax-deductible profit sharing contribution to a 401(k) plan is allowed on a discretionary basis. Up to 25% of compensation may be contributed to a 401(k) plan or 20% of net earnings if a self-employed business owner is unincorporated.  

Additionally, as an employee of the company, $18,500 of pre-tax elective salary deferral is allowed but may not exceed 100% of income for the year.  For those who are 50 or older, an additional contribution of $6,000 may be made in order to “catch-up” from previous years. Finally, the combined elective salary deferral and combined profit sharing may not exceed $55,000 for the current year.

What makes owner-only 401(k) plans so attractive to small business owners is the elective employee salary deferrals and profit sharing contributions.  Other types of retirement plans have lower contribution limits.

A sole proprietorship, partnership, or corporation may adopt an owner-only 401(k) plan.  However, the owner and spouse are the only ones who are eligible to participate in the plan.  If a business owner expects to add other full-time employees who will be eligible to participate in a 401(k) plan, the owner-only 401(k) plan would not be a feasible option for a business.

Highlights of Owner-Only 401(k) Plans

There are several highlights to an owner-only 401(k) plan:

  • Higher Contribution Limits – Offering the highest potential contribution limit compared to various qualified retirement plan, owner-only 401(k) plans are appealing to successful business owners who want to save considerable amounts for retirement.
  • Pre-Tax Contributions – Up to the stated maximum, any profit sharing contributions completed by the business, up to the stated maximum, are tax deductible as a business expense.  In 2018, any elective employee salary deferrals to the plan of $18,500 or less are not included in the employee’s income. This means that those contributions are made with pre-tax dollars.  In addition, catch-up contributions of $6,000 may be made for those 50 years of age or older in 2018.
  • Tax-Deferred Growth – Any gains and earnings on a 401(k)-plan account is not taxed until the investment is actually distributed.
  • Flexibility – The overall flexibility of contributions and deferrals are attractive to many business owners.  Both the elective employee salary deferral and the profit sharing contribution amount may be changed from year to year, or even skipped for a certain year.  This allows small business owners the flexibility when an unforeseen financial difficulty arises or to weather a rough business climate.
  • Easier Administration – An owner-only 401(k) plan is not subject to discrimination testing, since only the owner and spouse are employed by the business and are covered by the plan.  Additionally, no IRS filing requirements are needed until all plan assets exceed $250,000. Then, the IRS offers a streamlined form (Form 550-EZ), that is perfectly suited for small plans.
  • Access to Funds – There are certain plans that appeal to small businesses because they allow for withdrawals from the plan.  However, they do not allow for loans from the plan. SIMPLE retirement plans and SEPs allow owners to withdraw from the plan with a possible penalty tax and income tax burden.  Since these plans do not allow the owner to take a loan against the invested amount, many business owners opt for a 401(k) plan. An owner-only 401(k) plan not only allows withdrawals but can be set up to allow for loans too.  The loan is not subject to any penalty tax or income tax, but the loan must be repaid.

A financially secure retirement, the ability to increase contribution limits, and access to funds when needed are all good reasons that small business owners are turning to owner-only 401(k) plans.   

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