​401k Plan Designed for Business Owners

Posted by Cory List on 15th Mar 2015

Establishing an investment plan is the great way for both the employer and employees to ensure their income and lifestyle during retirement age. The flexibility and benefits offered by the recently modified Economic Growth and Tax Relief reconciliation marked the popularity of self-directed 401k plan among small business owners more than ever.

This plan is also called solo 401k or individual 401k, among others. Now, to get started with setting up your 401k plan, you have to know whether or not you are eligible to start with it in the first place. Any form of small business enterprise is eligible to participate in a 401k plan, whether it is a sole proprietorship, partnerships, or even corporations.

Technically, the only eligible participants within the business context are the owner and his spouse. Nonetheless, if there are other employees who may be qualified into the business owners’ self-directed plan provided that the following qualifications should be the basis for their eligibility:

  • Years of service – the years of service will determine the eligibility for income deferral contributions and profit sharing contributions. Commonly, small business owners limit the years of service requirement to one year.
  • Age – the common eligibility age for most 401k plans is 21 years old.
  • Salary amount – the amount of salary should be dependent on how many years the employee has been rendering service.

Like many other retirement investment plans, 401k plan for business owners have two indispensable components:

  • Salary-deferral contributions – business owners may have 100% salary-deferral contribution provided that it does not exceed to a salary-deferral limit in one year.
  • Profit-sharing contribution – employers have 25% contribution from your compensation.

The combination of these two components is also subject to certain limitations. In general, retirement investment plans provides many benefits which can be summed up into the following:

  • Employer contribution are reduced from the employer’s salary
  • Contributions are tax-deferred until distributed to employees
  • Investment fund accumulates while being tax-free

However, among all the investment plans available in the U.S. why is self-directed 401k plan considered as the most advantageous for business owners? Recent survey shows that almost 51 million U.S. small business employers and employees have created 401k plan due to the following reasons:

  • Income deferrals – employees have an employer-sponsored fund which is directly deposited into their 401k account every paycheck. This lifts them the burden of restraining themselves of spending their money. These deferrals are considered a pre-tax contribution although in some cases, it becomes after-tax—it all depends upon the employees’ option.
  • Matching contributions – employer’s contributions (tax-free) helps in accumulating retirement funds.
  • Easier maintenance – the administration of this plan is made easier through the prototype plans made by different financial institutions. So employers need lesser time to manage and maintain these plans.
  • Higher contribution limits – higher contribution limit means that both employers and employees can save larger amount of money for retirement.
  • Tax-free loan – a participant in a self-directed 401k plan is allowed to make a loan as much as $50000 (50% of an employee’s account value) which is payable for five years. This loan can be made regardless of where the money will be spent (e.g. personal use like credit card payment and shopping). This includes no upfront payment and minimal interest higher.
  • Wider investment opportunity – unlike other investment plans, 401k plans allow business owners to engage in almost all types of investment from mutual stocks and bonds to real estate businesses and others.
  • Free of discrimination testing – this is a required test for the original 401k plan to make sure that higher paid and lower paid employees have different contribution limits. This can be costly due to its extensive process. Luckily, handling a small business means you can just manually assess the contribution limit of each employee.
  • Safe from creditors and bankruptcy – both the employers and employees are safe from effects of bankruptcy by virtue of the Bankruptcy Code. The state also decides the protection of small business owners from creditors even outside bankruptcy situations.

Tax advantages of self-directed 401k plans

Small business owners understand the value of cheaper tax expenses in the pensions they provide for their employees. That is why 401k plans provide the following benefits:

  • Small business owners can take advantage of their tax credits as a start-up cost to open other types of plans (e.g. SEP and SIMPLE);
  • Self-employed and moderate-earners can also have tax credits based on the contributions made and credit rate. the credit rate starts from 10 percent up to 50 percent—it all depends to the gross income; and
  • A Roth or after-tax program which allows employees to have additional savings in other plans—additional way to save for retirement.

In addition to this great list of benefits of self-directed 401k plan is the convenience for business owners to open an account. Unlike other investment plans, this one doesn’t need banks or credit institutions to serve as trustees or custodians. In essence, this means a lot to business owners because they do not have to pay for a custodian’s fee anymore. Furthermore, since the sole decision and moves come from one person only, then one can make a move as quickly as possible when the right investment opportunity comes along.

In summary, self-directed 401k is designed to meet the needs of small business owners when it comes to tax advantage and investments. Compared to other retirement plans, it has high contribution limit which is not limited to employer contributions and salary deferral as well as advantageous tax benefits.