| NEW PENSION RULES IN THE ECONOMIC GROWTH
AND TAX Reconciliation Act of 2001 have provided
small business owners who have no employees other that their
spouse an incentive to set up a 401(k) plan. The changes mean
clients—and sole practitioner CPA firms—can contribute more to a
401(k) plan than to any other kind of defined-contribution
retirement arrangement. |
EFFECTIVE JANUARY 1, 2002, EMPLOYERS NO LONGER have to reduce their maximum tax-deductible retirement plan contributions by the salary deferrals employees make to a plan. This means an employer can contribute the maximum 25% tax-deductible profit-sharing contribution, plus any pretax contributions the employee makes.
CPAs SHOULD MARKET THE SINGLE-PARTICIPANT 401(k) to independent contractors, sole proprietors, and single-employee C and S corporations. They also should discuss it with so-called dual earners—those who have income from corporate directorships and freelance work in addition to their salary income from a corporation that offers a regular 401(k) plan.
SINGLE-PARTICIPANT 401(k) PLANS OFFER 100% TAX deferral of contributions, the ability to borrow from the plan and fewer administrative headaches than their corporate cousin. Businesses with immediate expansion plans should look elsewhere since the arrangement is only for single-employee businesses (plus the owner’s spouse).
|JULIETTE FAIRLEY is a freelance business writer in New York City. PETER D. FLEMING is a senior editor with the Journal of Accountancy . His e-mail address is firstname.lastname@example.org . Mr. Fleming is an employee of the AICPA, and his views, as expressed in this article, do not necessarily reflect the views of the Institute. Official positions are determined through certain specific committee procedures, due process and deliberation.|
he 401(k) plan has been around for more than 20 years, permitting Americans to amass billions of dollars in retirement assets. With the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) millions more self-employed or small business owners with no employees (other than their spouse) have a new incentive to set up a 401(k) plan and increase their retirement savings.
|The new rules apply to both
incorporated and unincorporated businesses. Any business that
employs only the owner and his or her spouse is a
candidate—including C corporations, S corporations, single
member LLCs, partnerships and sole proprietorships. This means
sole practitioner CPA firms and clients ranging from
consultants, entrepreneurs and lawyers to real estate brokers,
electricians and interior decorators are eligible to
contribute more to a 401(k) plan than to any other kind of
defined-contribution retirement arrangement, depending on
their earnings. |
This article reviews the basics of this retirement savings option and offers some tips on which small business clients CPAs should approach to recommend they set up and contribute to such a plan.
As a result of a provision in EGTRRA, effective January 1, 2002, employers no longer have to reduce their maximum tax-deductible retirement plan contributions by the salary deferrals employees make to a plan. This means an employer can contribute the maximum 25% tax-deductible profit-sharing contribution in addition to any pretax contributions the employee/plan participant makes. As a result, 401(k) plans have become more attractive options than SEP-IRAs, Simple IRAs or profit-sharing or money purchase plans. In addition, most plans accept rollovers of existing retirement plan assets.
Example. Mary Smith is the sole employee of an incorporated business. Her earned income is $100,000 in 2003. Under the law Mary can contribute $25,000 to a SEP-IRA, $8,000 to a Simple IRA, $25,000 to a profit-sharing or money purchase plan and $37,000 to a 401(k)—$25,000 employer contribution plus $12,000 employee deferral. If Mary were over age 50, she could also make “catch-up” contributions of $2,000 in 2003, increasing her 401(k) contribution total to $39,000.
Following these changes to IRC sections 404 and 415, mutual fund companies and retirement plan providers are beginning to offer single-participant 401(k) plans that give owner-only businesses the advantages of a traditional 401(k)—including higher contribution limits and the ability to borrow from the plan—at an affordable price. In 2003 the rules limit employer contribution to 25% of compensation. The employee can make salary deferral contributions up to $12,000. Together these contributions cannot exceed the lesser of $40,000 or 100% of compensation. (Catch-up contributions don’t count when computing this limit.) The maximum amount of compensation that can be considered when calculating deferrals is $200,000.
In some cases 401(k) plan contributions for an unincorporated business may be slightly lower than the above amounts. For unincorporated businesses, compensation is net profit minus half of self-employment taxes minus employer contributions.
Phyllis Bernstein is a one-person CPA/PFS firm who has investigated the new single-participant 401(k) plan for herself and her clients. The more the New York City-based planner looks at the new retirement product, the more she thinks CPAs are missing out on a potentially lucrative market.
“Because it’s still so new, not a whole lot of entities make the single-participant 401(k) available, so CPAs are more reluctant to get involved with it,” she says. “We tend to wait for our clients to ask us questions about new products. Sometimes we’re not proactive enough to go out and sell new products to existing clients.”
Christopher Guarino, president of plan administrator BiSys Retirement Services, agrees. “Previously, you could contribute only $10,500 under an employer’s 401(k) plan,” he says. “With a Keogh, you could contribute only $20,000. So the single-participant 401(k), which at BiSys we call the Individual (k), expands beyond a traditional 401(k) as well as a traditional Keogh.”BiSys is one of a handful of providers offering 401(k) plans for single participants; others include Pioneer, AIM, Scudder, BSW Benefit Plans Plus and Waddell & Reed (see resource list ).
What sets one plan apart from another are the fees and the products offered within each. For example, Waddell & Reed’s single-participant 401(k) plan, called the Exclusive K, requires no installation or setup fees but does charge an annual $15 custodial fee. “Participants can choose from 24 different mutual funds. You can have 1 fund or 15 funds and can mix and match,” says Deborah Zipp, assistant vice-president of retirement-plan-sales management for Waddell & Reed, a financial services firm based in Shawnee Mission, Kansas.
There are two natural markets for the single-participant 401(k). The first includes independent contractors, sole proprietors, and owner-only C or S corporations. The second market is those who have dual incomes. They are W-2 wage earners as employees of a company that offers a 401(k) plan who also have consulting income from corporate directorships or freelance work that requires them to file a schedule C as a sole proprietor. Zipp says these are the kinds of clients CPAs should be talking to about the new single-participant 401(k) arrangement because these dual earners traditionally are looking for a way to shelter additional retirement money.
Lest this arrangement seem too good to be true, Linda Johnson, CPA, PhD, associate professor of accounting at Kennesaw State University and a member of the AICPA employee benefits technical resource panel points out that if during 2003 an employee is already contributing the $12,000 maximum to a 401(k) or 403(b) plan at work, “then the benefits of establishing a single-participant 401(k) plan would disappear.”
The best time to broach the subject is during tax time, says Bernstein. Or, she says, “Send out a letter now to clients explaining how they can take advantage of this to prepare for next year by setting up an appointment during off-season to figure out whether it makes sense for them.” CPAs must enroll their clients before December 31, 2003, to make contributions for this year.
Steve Levey, CPA/PFS with GHP Financial Group in Denver, plans to approach all of his clients who file schedule C. “We’ll look at their net income and age and focus on anyone who earned between $40,000 and $120,000,” he says. “We’re going to call and e-mail them to tell them about this new way to fund their retirement that’s simpler, cheaper to administer and lets them put more money away—and save a lot in income taxes.”
FEATURES AND BENEFITS
To properly promote the single-participant 401(k) plan to both existing and potential clients, accountants must understand the advantages, disadvantages and how the plan operates.
The main benefit is the higher contribution limits. This is particularly powerful when added to the 100% deferral of contributions available to all qualified retirement plans. If the client hasn’t put enough money away for retirement and he or she is over age 50, CPAs can recommend the catch-up provision ($2,000 in 2003) to allow him or her to increase the amount that will be set aside. “The money in a self-employed 401(k) plan grows on a pretax basis like any other pension plan or IRA,” says Neil Schwartz, CPA, CFP in Boca Raton, Florida. “So the client has 100% of his or her money working and growing without any current taxation. You get taxed only on the amount you take out at retirement, not the amount that is left there to grow.”Many self-employed people and small business owners face cyclical cash flow. The single-participant 401(k) offers a solution to this by allowing participants to borrow from the plan. The same withdrawal and borrowing rules that apply to employees taking loans from their employer’s plan apply to a single-participant 401(k).
Although single-participant 401(k) plans are limited to the business owner and his or her spouse, Johnson reminds CPAs to point out to business owners “the added benefits of having his or her spouse be the business’s only other employee.” She points out that “having the spouse on the payroll gives the client the opportunity to shelter some or all of his or her income by having the spouse make an elective deferral to a 401(k) plan in addition to the business making a contribution.” Although the spouse and the business would be responsible for their respective share of employment taxes on the salary, combined employer and employee contributions can be up to the lesser of $40,000 or 100% of compensation.
The downside. The single-participant 401(k) does have some disadvantages. If the one-man band grows enough to hire employees, the single-participant 401(k) plan must become a full-blown 401(k) plan subject to other more stringent rules including discrimination testing that can serve to limit contributions by highly paid executives. Many providers recommend that businesses with immediate expansion plans not set up one of the new single-participant 401(k) arrangements.
Another downside in the single-participant 401(k)’s brief history it is that because it is still less than two years old, only a small number of mutual fund sponsors and retirement plan providers make it available. That means clients who are used to being able to select from among literally thousands of retirement plan providers have only a handful of choices. This may limit the range of investment options and make it difficult to shop for low-cost alternatives.
THE REST OF THE STORY
Since most CPA firms aren’t set up to administer retirement plans of any kind in-house, they will prefer to refer clients to an independent custodian and plan administrator. Schwartz doesn’t charge his clients a setup fee for helping them enroll in a single-participant 401(k) plan with a mutual fund family. Instead that company compensates him on the sale of mutual funds within the plan.
CPAs will find the rollover market—clients who are leaving a corporate job to start their own business—a good one to target with a single-participant 401(k). The amount of money a client can roll over or consolidate from other plans is unlimited and not subject to the $40,000 annual contribution limit. The result is a better retirement option for the client and a bigger ticket for the CPA/financial planner says Walter Pardo, a registered investment adviser for McLaughlin, Piven, Vogel Securities who sells Pioneer’s Uni-K plan in New York.
The key to this strategy is persuading clients to roll over their retirement money into a single-participant 401(k) plan rather than an IRA. The downside of doing so is that an IRA has no reporting requirements whereas the IRS requires a 401(k) plan to file form 5500 once the balance exceeds $100,000. CPAs can, of course, help clients complete this form, usually for an additional fee.
The main selling point of a 401(k) is that it allows much larger tax-deductible contributions than an IRA. It’s important for CPAs to remind clients that unlike some IRAs, a single-participant 401(k) plan has no investment restrictions. To help achieve greater diversity, participants can invest with more than one mutual fund family or custodian. “Initially it wouldn’t pay to use more than one sponsor,” says Schwartz. “But when you start getting a couple hundred thousand dollars in the plan, the client might be more comfortable with two agreements with two companies, which results in a more diversified portfolio,” he points out. CPAs can help clients compare the resulting fees to make sure such an arrangement makes sense.
A BETTER DEAL
The tax law changes described here provide a compelling reason for CPAs to recommend that owner-only businesses consider sponsoring 401(k)-type retirement plans. The arrangements enable such businesses to maximize retirement contributions and shelter a significantly greater portion of their income than previously available alternatives. In most cases the single-participant 401(k) is less complex, less burdensome to administer and less expensive to maintain than its big-company namesake. The bottom line for CPAs is this plan deserves serious consideration—for both clients and for sole practitioner CPA firms.
|Resource List |