The Benefits of Individual 401(k) Plans

By John Wollenberg, CPA, PFS, MBA, J.D., Friedman LLP, East Hanover, NJ (not affiliated with CPAmerica International)

Editor: Michael D. Koppel, CPA, PFS

As more taxpayers become self-employed during these difficult economic times, more face the important decision of choosing the most advantageous retirement plan for themselves. This item highlights the features of the still relatively new individual 401(k) plan and shows how, in certain circumstances, this type of plan can provide for a more powerful contribution.

The Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16, authorized self-employed individuals to add a 401(k) feature to their profit-sharing retirement plans. This change astutely recognized the dual roles every self-employed person plays, one as the employer and the other as the employee.

As the employer, a self-employed 401(k) owner can make a profit-sharing contribution of up to 20% of earnings (25% of net earnings). As the employee, the selfemployed individual can make elective deferrals of up to $16,500 in 2009 ($22,000 if age 50 or over). By combining these two contribution components, some self-employed 401(k) plan owners (or members of LLCs) may be able to reach the maximum 2009 total contribution of $49,000.

By comparison, simplified employee pensions (SEPs) or profit-sharing Keogh plans would allow 2009 contributions for the self-employed to the extent of the lesser of 20% of earnings or $49,000.

Exhibit: Comparison of SEPs and individual 401(k) plans

SEP Individual 401(k)
Schedule C income $100,000 $100,000
Less: One-half of selfemployment tax (7,065) (7,065)
92,935 92,935
Employer contribution @ 20% (18,587) (18,587)
Self-check: $18,587 is 25% of 74,348 74,348
Employee elective deferral 0 (16,500)
Earnings after contributions $74,348 $57,848
Employer contribution $ 18,587 $ 18,587
Employee contribution 0 16,500
Total retirement contribution $18,587 $35,087


As a comparison, the exhibit above demonstrates the increased contribution and corresponding deduction available to those self-employed taxpayers who select an individual 401(k) with Schedule C income (after expenses) of $100,000.

With a Schedule C net profit of $100,000, a self-employed individual choosing an individual 401(k) type retirement plan instead of a SEP will be in a position to contribute $35,087 rather than $18,587, an increase of $16,500, representing the employee elective deferral amount.

Practice tip: Those who are self-employed and whose net earnings exceed $200,000 will find that an individual 401(k) will not offer a significant benefit over a SEP. At lower and moderate income levels, however, the individual 401(k) offers the possibility of proportionately more contributions.

Setup and Filing Rules

An individual 401(k) must be set up and partially funded before the end of the taxpayer’s tax year, whereas a SEP can be established and funded any time up to the timely filing of the taxpayer’s return for the year (including extensions). In addition, an individual 401(k) could give rise to an annual Form 5500 (Annual Return/ Report of Employee Benefit Plan) filing requirement, while no such filing is needed for a SEP.


Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.

For additional information about these items, contact Mr. Koppel at (781) 407-0300, or

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.