Let’s take a comprehensive look at the various components of an owner-only 401(k) savings plan and how both employers and employees can benefit.
Contributions to an Owner-Only 401(k) Plan
- Employer – Contributions by the business to the plan are tax-deductible in the year made, up to specified maximum amounts. In addition, employer contributions are not currently taxable to the employee.
- Employee – Elective employee salary deferrals are not included in the employee’s taxable income, meaning that they are made with before-tax dollars.
The growth of an Owner-Only 401(k) Plan
The contributions made to an owner-only 401(k) plan from the employer and employee are placed into the employee’s account. Once placed into the account, the funds are then invested. Any earning and gains made from these investments are not taxed until the owner receives them in the form of distributions. Investment growth allows for a potentially larger accumulation versus the current taxable retirement accumulation alternatives.
Distributions of an Owner-Only 401(k) Plan
Owner-only 401(k) plan contributions are made with pre-tax dollars. The amount is not taxed until it is distributed to the owner during retirement. Once these deferred dollars are distributed, the owner must include this income as gross income and pay tax on the received amount.
An owner-only 401(k) plan stipulates that minimum distribution requirements are met. When these distributions are made mandatory only applies to participants once they reach age 70 ½ or the year when the participant actually retires, if they retire before age 70 ½. Distributions from a 401(k) plan may be distributed as:
- Lump Sum Distribution – Just as the name implies, the entire balance is received all at once. For participants who were born before 1936, special tax treatment is available. For all other participants, the lump sum amount is subject to income tax in the year the lump sum was distributed. However, in order to defer taxation, the entire amount may be rolled over to an IRA or another qualified plan.
- Periodic Payments – Payments received annually or more frequently may be made over the life of the participant, over the life of the participant and designated beneficiary, or for a set period of time. This assumes that all contributions made to the plan were on a pre-tax basis. Just as with a lump sum payment, periodic payments are also subject to income tax based on the year they were received.
Advantages and Disadvantages of an Owner-Only 401(k) Plan
There are several advantages to contributing to owner-only 401(k) plans:
- Higher Contribution Limit: Other widely used small businesses offer a variety of retirement plan, but only an owner-only 401(k) plan allows for higher contribution limits. This is an attractive feature if the goal is saving for retirement.
- Pre-Tax Contributions: Not only are any elective salary deferrals not included in income for the business, but the business may deduct any contributions it makes to the plan.
- Tax-Deferred Growth: There is no tax payable on any gains or earnings on 401(k) plan investments until the money is distributed.
- Flexibility: There is great flexibility with contributions. They may be increased, decreased, or skipped at the will of the business owner.
- Access: Unlike most other plans, an owner-only 401(k) plan allows for withdrawals and loans from the account.
- Rollover: Other retirement plan funds may be rolled over into the owner-only 401(k) plan. This allows for all retirement funds to be managed under the owner-only 401(k) plan.
- Easier Administration: Reporting to the IRS is done on a simplified “EZ” form. Nondiscrimination testing is not required since the only one eligible is the owner and the owner’s spouse.
There are a few disadvantages to an owner-only 401(k) plan:
- Potential Business Growth: The only ones eligible to be covered under the owner-only 401(k) are the business owner and spouse. If the business grows enough over time to hire full-time employees, then the plan switches to a regular 401(k) plan. This means that the 401(k) plan is then subject to discrimination testing, administration requirements are more involved, and there are possible limitations on the size of contributions made to higher-paid employees.
- Administrative Requirement: SEP and SIMPLE IRA plans do not have administrative requirements, such as a plan trustee and record keeping, while an owner-only 401(k) plan does.
- Multiple Plans: If a person is eligible to participate in another employer’s retirement plan, they may not be eligible for the maximum amount of contributions to an owner-only 401(k) plan.
An Owner-Only 401(k) Plans Power
When comparing an owner-only 401(k) plan to other types of plans, the tax advantages, which include pre-tax contributions and deferred growth – allow for the substantial opportunity for the accumulation of money for retirement. When comparing this amount to after-tax contributions, which are taxed yearly.
The Roth 401(k) Option
Just like a Roth IRA, which takes taxes out at the time of contribution, the Roth 401(k)s contributions are also subject to taxation at the time of contribution. The tax advantage and overall appeal for the Roth 401(k) include the growth of the account and the distribution of funds from the account are completely free of federal income tax. The qualified tax-free distribution must be made more than five years after establishing the Roth 401(k). The plan participant must also have reached age 59 ½, be disabled or deceased. In addition, $10,000 of the funds may be used to purchase a first home.
If the plan allows, participants may be allowed to roll over all or part of their regular 401(k) account to a Roth 401(k). Federal income tax must be paid on the rolled over amount to be distributed tax-free.
Considerations for a 401(k) plan with a Roth option include:
- Paying taxes at a later time by contributing pre-tax dollars to a regular 401(k) account. This money will grow tax-deferred until distributed.
- Paying taxes now by contributing post-tax dollars to a Roth 401(k) where funds grow tax-free and are received on a tax-free basis.
- Splitting elective salary deferrals between a Roth 401(k) and regular 401(k) account. The best of both worlds allows for some funds to be contributed tax-free and other funds to be contributed after tax but received tax-free.
To avoid paying unforeseen tax consequences or investing in an unwanted 401(k), consult a professional tax advisor before depositing or transferring any funds from a regular 401(k) to a Roth 401(k).