Individual 401k Plans Improvements

Even though being single is not the most pleasant thing as regards your personal life, think of the advantages that this status gives you in terms of financial conditions. The most obvious example is the retirement-savings field.

The new pension reforms that were established by the Economic Growth and Tax Relief Reconciliation Act in 2001, makes it possible for self-employed to allocate more money to their pension funds. This in turn gives a comparative advantage relative to the regular retirement plans like Keogh and the Simple Employee Pensions. This was caused by the increase of the deduction limits that can be contributed.

Micro plans (single-participant 401ks) are viewed as the most fast developing fields of the defined-contribution market. What made 401k plans an attractive investment destination is the ability of self-employed to make higher contributions. Before the implementation of the EGTRRA, which provided for this opportunity, employees were allowed to contribute to regular 401ks but, didn't have the sufficient motivation to do so.

Having realized the huge attraction that was created as a result of the new regulations, many financial entities, such as fund companies and insurance companies, grabbed the opportunity and launched 401ks for sole proprietors. Due to the immerged high demand, the number of companies that offered this type of retirement plans increased significantly, making it hard to find one that doesn't offer such a 401k plan.

Another trend that is observed is the huge percentage of rollovers to individual 401ks due to the new opportunities. The investors truly realize the benefits they gain from them and transfer their resources.

Before the implementation of the EGTRR, the employee's salary deferral and the employer's contribution were included in the total deductible contributions to the 401(k), limiting it to 15% of the total compensation. This amount could not exceed $170,000. Under the new pension regulations the contributions' amount is significantly increased amounting to 25% of total compensation, but not exceeding $200,000.

The solo 401k plan provides the employees with the possibility of contributing a salary deferral in addition to a profit sharing contribution. As compared to the Keogh, the latter allowed only for profit-sharing contributions. In both cases the contributions made throughout the year cannot exceed $40,000.

The good news is that under the new reforms, an employee working for a small business enjoys the same financial status as one working for a large company with regards to retirement plan contributions.

In order to feel the difference imagine you have an annual salary of $40,000. You can make 25% of the compensation in the form of contribution to a profit-sharing plan, which amounts to $10,000. You should add $11,000 which represents the maximum amount for 2002 for 401k plans. Thus your overall yearly contribution is $21,000. There is a catch-up contribution that can be made by those at the age of 50 or above, which amounts to $1,000 and continuously increases by $1,000 until the year 2006. On the other hand, if you are under the conditions of a regular profit-sharing plan, you will be able to contribute as little as $15,000.

There is no difference in the contribution limits experienced under the conditions of a traditional profit-sharing plan and a single-participant 401 (k) plan. But this is only in case your annual salary is at least $160,000. Thus, you are allowed 25% of the compensation.

Tax Implications

The bad news is that these increases have some tax implications. You are subject to Social Security taxes on the deferred contributions. On the other hand, your employer is not obliged to pay any taxes concerning contributions made. The tax percentage is paid by both employer and employee, but since you are self-employed you should provide for both parts.

The old age, survivor and disability components are included in the Social Security tax, which amounts to 6.20% and is limited to $84,900. On the other hand, there is no limit on the Medicare portion, which is owed on all wages and is 1.45%. As a result, self-employed are liable to 15.30% Social Security tax on the salary deferrals they make.

Net Earnings Calculations

The new regulation requires a different approach about the way self-employed should calculate their compensation.

Net earnings = gross earnings - (1/2 of self-employment tax + contributions to a retirement plan)

The logic behind the establishment of a 20% limit to the contributions made from the gross income is that the self-employee's net earnings and the contributions made are dependant on each other.

Conclusion

Despite the existence of some negative aspects, it is still worth for the self-employed to contribute to a 401k plan. The many offers of single-participant 401k plans differ from one another in their costs and investment options. It has been calculated that the average cost to invest in a 401k is approximately 0.76% of assets. However, most single-participant 401k plans tend to prefer retail shares, which may increase the expenses. Another issue that should be considered is paperwork. Many companies provide the option of self-directed brokerage or an automated administrative feature. So, consult with the company whether it does provide these services.

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