Independent contractors deserve retirement too.

Independent contractors deserve retirement too.

Independent contractors, like many small business owners, are afforded various strategies under the Internal Revenue Code that may help reduce their tax burden.  Many of those tax advantages, however, are accomplished by reducing the company profit and, therefore, potentially reducing the amount that can be contributed to a retirement account.  At least this was the case until 2001.  In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act, which created the One-Person 401(k) plan, also known as the Solo 401(k).  This retirement account is designed for independent contractors and small businesses that do not have employees.  This 401(k) plan opened the door for independent contractors to continue using corporate tax planning strategies while also taking advantage of a retirement plan to reduce their personal income tax.  

To illustrate how the One-Person 401(k) works, I would like to compare it to the commonly used SEP (Simplified Employee Pension) Plan.  The One-Person 401(k) has many of the advantages of a SEP plan, but allows for higher contributions and flexible timing of those contributions.

First let me explain what the SEP and the One Person 401(k) plans have in common.  Both the One-Person 401(k) plan and the SEP retirement plan have a profit share contribution in common.  This profit share contribution is typically made after the business year is over and as taxes are being prepared.  Both plans allow sole proprietors to contribute up to 20% of their gross income minus one-half the self-employment taxes.  Another way of stating this is {20% * Net adjusted business income}.  If, however, your business is incorporated or is structured as an LLC, you will typically be receiving W-2 compensation and perhaps a passive income as either “dividends” or “draws” from your business.  In this case, you can only use the W-2 portion of your income to fund your retirement.  The profit share contribution is equal to 25% of your W-2 compensation.  

Two common problems arise from the SEP or profit share contribution formula for retirement plans. First, if you are incorporated or an LLC and have lowered your W-2 to reduce your employment taxes, you also inadvertently reduce the amount you can contribute to a traditional retirement account.  Second, the profit share contribution must be deposited by the due date (including extensions) for filing your Federal income tax return for the year.  Therefore, at the very moment you are faced with paying your taxes, you are asked to contribute to your SEP account.  This can be a double whammy for your cash position.    

So how does the one-person 401(k) plan go beyond that of a traditional SEP?  The one-person 401(k) allows, in addition to the profit share contribution discussed above, a 401(k) contribution for the employee.  That is, the independent contractor or small business owner is allowed to contribute up to an additional $16,500 if they are under age 50.  Or if they are 50 or older, the 401(k) contribution goes up to $22,000 with the additional $5,500 (for 2009) catch up.  Also, the timing of the contributions is flexible.  Contributions can be made any time throughout the calendar year.  You can contribute a little bit monthly, as your income is earned, or in a lump sum at the end of the year.  Of course, I have described the maximum contributions allowed.  You are allowed to contribute any amount under the maximums and there is no obligation to contribute anything at all.  It is entirely up to you.  

One more feature that the one-person 401(k) offers that other small business plans don not, is a loan feature.  Participants that have not already taken a loan in the prior twelve months are allowed to borrow up to one-half their vested account balance up to a maximum of $50,000, and pay it back over no longer than five years.  Liquidity is often a concern for independent contractors, and a loan feature may reduce the stress involved with making a retirement plan contribution.   

The one-person 401(k) plan is a powerful and flexible retirement plan choice.  However, it is just one type of retirement plan available to independent contractors and small business owners.  To evaluate what plan is best for you, please consult your tax, legal and financial advisors.  
For more information about this topic, please visit our website at: www.fa.smithbarney.com/piersonrussigroup  


Christopher H. Russi is the Second Vice President – Wealth Management, Chartered Retirement Plans Specialist sm at Morgan Stanley Smith Barney, LLC Member SIPC.

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