Being Single in a 401(k) Just Got Better

If you think being single is tough, try it in the retirement-savings arena. But help has arrived.

New tax rules are making it easier than ever for the self-employed to stash away more money for retirement. The Economic Growth and Tax Relief Reconciliation Act of 2001 guidelines regarding contribution and deduction limits are giving 401(k) plans a competitive edge over traditional plans, such as Simple Employee Pensions and Keoghs.

Single-participant 401(k)s, or micro plans, are the fastest-growing segment of the defined-contribution market, according to Boston-based business consultants Cerulli Associates. The self-employed have always been able to invest in regular 401(k)s. But it wasn't until EGTRRA, which allows the self-employed to contribute more money to 401(k)s with fewer limitations, that they became an attractive investment choice for sole proprietorships.

As a result, insurance and fund companies are launching a slew of single-participant 401(k) products. "It's pretty hard to throw a dart and not find a provider offering a solo 401(k) product," says Nevin Adams, editor of employee benefit news Web site Plansponsor.com.

And there's a huge market to supply. According to ExpertPlan, an Internet-based provider of retirement plans, there are almost 18 million one-person companies in the U.S., which account for nearly $1 trillion in annual revenue.

Take Pioneer's Uni-K Plan, launched in January of this year. About half the accounts are rollovers from other plans, according to company spokesperson Tara Pescatore. In March, Scudder Retirement Services, a division of Zurich Scudder Investments, released the Scudder Personal(k). John Hancock Funds launched T(k)O (Total 401(k) for Owners) in May, and CUSO Financial Services introduced Solo 401(k) Your Way in July.

The new EGTRRA rules on contribution limits and deductibility for 401(k) plans allow substantially higher total contributions per employee than were permissible under the old law. Under previous tax rules, total deductible contributions to a 401(k) plan by an employer included both the employee's salary deferral and the employer's contribution, limited to 15% of total compensation up to $170,000. Under the new rules, total deductible contributions to a plan by an employer exclude employee salary deferrals and are raised to a limit of 25% of total compensation up to $200,000.

In other words, the self-employed can make a profit-sharing contribution as well as a salary deferral into a solo 401(k). In a Keogh, on the other hand, the self-employed can only make a profit-sharing contribution. Both plans have a contribution limit of $40,000 per year.

"These new rules will enable people to set aside money for retirement at the same rate as somebody working for a large company," says Adams at PlanSponsor.com.

For example, a person who makes $60,000 a year could contribute 25% of his pay, or $15,000, in a profit-sharing contribution, and another $11,000 -- which is the maximum amount for 401(k) contributions in 2002 -- for a total of $26,000. EGTRRA also allows participants age 50 or over to contribute "catch-up contributions" in the amount of $1,000. That limit increases each year by $1,000 until 2006. With a traditional profit-sharing plan, however, a person can only contribute $15,000.

For those who make $160,000 or more, the contribution limit is the same for both single-participant 401(k)s and traditional profit-sharing plans -- 25% of $160,000 is $40,000 -- the most the self-employed can put in a 401(k) per year.

In some cases, however, taxes take a bite out of these increases.

"Contributions you make are subject to Social Security taxes, whereas contributions your employer makes aren't," says Ted Benna, president of the 401(k) Association. In other words, you will have to pay Social Security taxes on any salary deferral you make into your 401(k). "For some, that rate is close to 16% of the money contributed by the subject," says Benna.

The Social Security tax, also known as the Federal Insurance Contributions Act, or FICA tax, is split between the employer and the employee. So the self-employed has to pay both parts. The Social Security tax includes the old age, survivor and disability portion, which is paid up to a limit of $84,900 and has a rate of 6.20%. The Medicare portion is paid on all wages, without limit, and has a rate of 1.45%. So the total Social Security tax rate the self-employed pays on salary deferrals to 401(k)s is 15.30%.

Another bite comes from the way the self-employed must calculate their compensation, or net earnings. They must deduct from their gross earnings one-half of their self-employment tax, plus their own contribution to a qualified retirement plan. Because their own contributions and their net earnings depend on each other, the actual percentage the self-employed can contribute of their gross income is 20%, according to Richard O'Donnell, an editor at RIA's Federal Taxes Weekly Alert.

He adds, "[Despite these deductions,] for the first time, it makes sense for the self-employed to have a 401(k)."

The difference between the various single-participant 401(k) plans depends on cost and selection of investment options. According to a 2002 report by CRA RogersCasey/Institute of Management & Administration, the average expense to invest in a 401(k) is 0.76% of assets. But single-participant 401(k)s are more likely to invest in retail shares, rather than the less expensive institutional shares, says Adams. As a result, expenses for solo 401(k)s might be slightly higher than the average reported in the CRA RogersCasey/IOMA study.

"The consumer might also want to look at whether the plan has a self-directed brokerage option appended to the 401(k)," adds Adams, "or an automated administrative feature. That would free the entrepreneur from paperwork and provide more time to do business."

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