Advantages of a one-person 401(k) plan

One-person 401(k) plans are becoming increasingly popular for businesses that employ only their owner. Given the right circumstances, these plans can allow a large amount to be contributed on behalf of the owner while maintaining flexibility in making contributions in future years. The cost of preparing the annual return (Form 5500-EZ or Form 5500-SF required after plan assets exceed $250,000) is nominal in comparison to the additional funding a one-person 401(k) plan allows. Also, because the plan has no employees other than the owner, it is not subject to the complicated nondiscrimination tests that normally apply to 401(k) plans.

For 2017, a business owner can make an elective deferral contribution of up to $18,000 ($24,000 if he or she is age 50 or older) plus an employer contribution of up to 20% of self-employment (SE) income or 25% of compensation. In calculating the allowable employer contribution, the owner's SE income or compensation is not reduced by the owner's elective deferral contribution (Sec. 404(n)).

Note: Catch-up contributions can be made by individuals age 50 and over if the plan allows. Catch-up contributions are not subject to any other contribution limits. For 2017, the catch-up limit is $6,000 for qualified plans and $3,000 for SIMPLE plans.

However, the total contributions (elective deferral plus the employer contribution) cannot exceed the lesser of 100% of the participant's compensation or $54,000 ($60,000 if age 50 or older) for 2017.

Example. Maximizing contributions with a one-person 401(k) plan: R, age 50 (by the end of the current year), is the sole owner and employee of a sole proprietorship. The sole proprietorship is also the sole source of R's earned income. R earns $180,000 (net of the SE tax deduction) in the current year and wishes to maximize contributions to a retirement account. R believes that the business will probably continue to be profitable, but he would like the flexibility of determining on a year-to-year basis how much to contribute. R does not expect to hire employees and will remain a one-person company.

The table below reflects the maximum amount that can be contributed to a profit sharing plan with a 401(k) feature (a one-person 401(k) plan) by R in 2017. In contrast, R's 2017 contribution to a profit sharing plan without a 401(k) feature or a SEP without a salary reduction feature (a regular SEP) would be limited to $36,000 (20% × $180,000).

R’s maximum contributions to a one-person 401(k) plan

Note: Catch-up contributions for employer retirement plans are available only for plans that allow elective deferrals (401(k) plans, 403(b) plans, SARSEPs, and SIMPLEs). If R had chosen to use a profit sharing plan without a 401(k) feature or a regular SEP, there would be no additional catch-up contribution available for being age 50.

One-person 401(k) is less advantageous at higher income levels

The higher the business owner's SE income or compensation, the more can be contributed to his or her one-person 401(k) account—up to the applicable dollar cap (i.e., the annual additions limit). For 2017, the cap on combined elective deferral and employer contributions to a 401(k) plan account is $54,000 if the owner is under age 50 (Sec. 415(c)(1)(A)). The 2017 cap for a profit sharing plan without a 401(k) feature or a regular SEP is $54,000, regardless of the owner's age (Sec. 415(c)(1)(A)).

Because of the $54,000 cap (for 2017), the advantage of a one-person 401(k) plan over a SEP is maximized when SE income is $180,000 or less (because the full $18,000 elective deferral is available even with an employer contribution at the maximum 20% rate). On the other hand, when SE income is $270,000 or more, there is no longer an advantage because the full $54,000 limit can be contributed using a SEP ($270,000 × 20% = $54,000).

Similarly, the $54,000 cap impacts the advantage of a corporate one-person 401(k) versus a SEP, except the amounts are different because the corporation can contribute 25% of the individual's compensation (without any reductions). Thus, the maximum advantage of the 401(k) is realized on compensation up to $144,000 ($144,000 × 25% = $36,000 corporate contribution + $18,000 individual deferral = $54,000 cap), and the advantage is lost when compensation is $216,000 ($216,000 × 25% = $54,000 cap) or more.

However, when the business owner is age 50 or older, a one-person 401(k) plan will always permit larger annual deductible contributions. This is because the 401(k) cap is increased by the catch-up elective deferral contribution amount. The 401(k) cap for 2017 for a participant who is age 50 or older is $60,000 ("regular" cap of $54,000 plus $6,000 extra due to the catch-up contribution privilege) (see Secs. 402(g)(1), 414(v), and 415(c)(1)(A)).

The business owner can borrow from his or her 401(k) account, assuming the plan document so permits. The maximum loan amount is 50% of the account balance or $50,000, whichever is less. In contrast, borrowing from a SEP or SIMPLE is forbidden (Secs. 408(e)(2), 4975(c)(1)(B) and (d)(1), and 4975(f)(6)(B)).

When the business employs someone other than the owner, 401(k) contributions may be required for the other employees, in which case the plan would become a "standard" 401(k) plan with all the resulting complications. However, the plan can exclude from coverage any employee who is under age 21 and any employee who has not worked for at least 1,000 hours during any 12-month period (Secs. 410(a)(1)(A) and (a)(3)(A)). Because this exclusion rule allows the business owner to avoid covering young and part-time employees, the plan may still qualify as a simple and easy one-person 401(k) arrangement.

A one-person 401(k) plan is subject to the same deadlines as self-employed qualified retirement plans. Therefore, the plan must be established by the end of the year for which it is first effective, and contributions must be made by the due date of the self-employed person's return, including extensions.

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 18th edition (March 2017), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).