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The Power of the Solo 401(K) Plan

06.26.15

The question I had often wondered about is why a sole business owner, with no employees except for him or herself, would want to set up a 401(k) plan when they could simply set up a profit sharing plan. Why all the brokers were touting the wonderful things about setting up a 401(k) plan for the business owner with no employees? Then one day I decided to crunch the numbers, and low and behold it made perfect sense.

Before going into the calculations, it is important to make sure you are aware of certain statutory rules that make this work. These are as follows:
  1. The maximum deductible contribution to a profit sharing plan is 25% of aggregated participant compensation.
  2. 401(k) deferrals are not subject to the 25% deduction limitation.
  1. The maximum elective deferral limit for 2015 is $18,000.
  2. The maximum that any participant in a defined contribution plan (profit sharing/401(k) plan) can generally receive is the lesser of 100% of compensation or $53,000 in 2015 (the “Section 415 Limit”).
  3. Starting in the year in which an individual reaches age 50 and subsequent years, a 401(k) plan may allow the individual to make a “Catch-Up Contribution.” The Catch-Up Contribution for 2015 is $6,000. The Catch-Up Contribution does not count against the deduction limit, the maximum elective deferral limit, or the Section 415 Limit.
You should also know that a sole 401(k) plan will work for a business classified as a sole proprietor, limited liability company, or corporation.
 
Now that we have those basic limitations out of the way, the following examples will set forth the power of the solo 401(k) plan.
 

EXAMPLE 1: The sole shareholder of the corporation has annual compensation of $100,000. With a profit sharing plan, the maximum contribution would be the lesser of 25% of eligible compensation (the deduction limit) or the Section 415 Limit of $53,000. Therefore, the maximum contribution is $25,000.

EXAMPLE 2: Using the same facts as in Example 1 but by adding a 401(k) feature, the maximum benefit that the owner can receive is now increased from $25,000 to $43,000 by making an elective deferral of $18,000. The 401(k) deferral is not subject to the 25% deduction limitation.

EXAMPLE 3: The sole shareholder of the corporation now makes $150,000 per year. The maximum allowable contribution to a profit sharing plan is $37,500 (25% deduction limit). By adding the 401(k) feature, the maximum contribution is now increased to $53,000. The Section 415 Limit now comes into play.

EXAMPLE 4: Now assume the same facts as in Example 3 except that our business owner is age 55. This has no impact if it is only a profit sharing plan. However, the maximum contribution with the catch up contribution of $6,000 now is increased to $59,000.

Once the numbers materialize, the power becomes quite obvious of such a simple arrangement.