401k Plans for Small Business Owners - Eligibility Requirements for an SBO-401(k), making 401k Elections, Salary Deferral & Profit Sharing Contribution Limits & Example

(September 23rd, 2009)

The economic reforms brought about by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) have made 401k plans very easily accessible and easy to set up for small business owners who do not necessarily have employment incomes but self-employment incomes or net business incomes. 401k plans developed for small business owners are also known as “Small business owner 401k” or “SB0-401K.” Other financial advisors call the small business owner 401k as “Solo 401k” or “Self Employed 401k” or “Individual 401k plans”, whatever it may be; we will call it a small business owner 401k. A common misconception of small business owner 401(k) plans is that they are only set up for sole proprietorships but this is not true. Small business 401k plans can be set up by partnerships or corporations that are small in size, usually with a market capitalization of $1 billion or less. Also, small businesses including partnerships & corporations can only set up 401(k) plans if they are owned by a single owner and that the only eligible plan participants are the business owners.

The ease with which small business owners can set up 401(k) plans for their businesses has been made even simpler. This is because most financial institutions have developed cut-down or very easy versions of regular 401(k) agreements that large corporations would normally have, and they are available for use to small business owner 401(k). For instance, a document designed for regular 401k plans might be 30 pages, however documentation designed for SBO-401(k)s could be trimmed down to 3-5 pages; this is much easier to read and manage.

Eligibility Requirements for a Small Business Owner 401(k) Plan

As mentioned above, one of the eligibility requirements for SBO-401k plans is that they can be adopted only by small businesses in which the employees eligible to participate in the plan are actually the small business owners themselves. Also, the owner’s spouse is also considered an owner of the business for eligibility purposes. For instance, if you are the male owner of your small business and your wife works for you, she is also eligible to participate in the small business owner 401(k) plan. Note that other than your spouse, if you have other lower level employees that work in your small business and who are eligible to participate in the 401(k) plan, then you are NOT eligible to set up a small business owner 401(k) plan. However, if you have other non-owner employees working for your small business and they are NOT eligible to participate in a 401(k) plan, then most certainly you are allowed to set up an SBO-401k plan.

So the next logical question you might ask is, how do I determine if my employees are eligible to participate in a 401(k) plan? Well these eligibility requirements are set by your 401(k) documentation or agreement. Any eligibility requirements that you set must be within these limitations:

i) You must exclude those employees who are less than 21 years of age as they are not eligible for contributing to a 401(k) plan.

ii) You can require your employees to perform at least one years’ worth of service before they become fully eligible to participate in a 401(k) plan and before they can make salary deferral contributions.

iii) You can require your employees to perform at least 2 years worth of service before they become eligible to receive profit-sharing 401(k) contributions from your small business.

For eligibility purposes, an employee is considered to have performed 1 year of service if he/she has continually worked for a minimum 1000 hours in 1 year. While most small business owner 401(k) plans stick to this rule, some employees prefer to change the # of hours to higher or lower, depending on their business & labour requirements.

Comparisons of Small Business Owner 401(k) with Other Retirement Plans

The sum of $49,000 in salary deferral and profit-sharing contributions that can be made to a small business owner 401(k) plan is very high when compared to contribution limits of other retirement plans. Take for instance the maximum Roth IRA contribution limit for 2009 is just $5,000 while the maximum contribution limit to a regular 401(k) plan is just $16,500. Below is a summary of contribution comparisons of popular retirement plans with the SBO-401k.

Example: Suppose John who owns a little IT consulting company makes $80,000 net profit for the year 2009. John wants to set up a 401(k) plan for his business and wants to set up a plan that allows him to make the most of salary deferral contributions and to minimize his current tax payable via salary-deferred contributions. The table below outlines what John will be able to contribute to each of the above plans to the maximum.
Note: John is 45 years old and thus does not qualify for catch up contributions.

From the table & graph above, we clearly see that small business owner 401(k) plan allows for the highest contribution of $32,500 in John’s case. The regular 401(k) plan comes in second at $16,500 and the SEP IRA and profit-sharing plan are tied in 3rd place at $16,000. The Simple IRA comes in fourth place at $13,900.

Be Careful when Making 401(k) Elections

When setting up your official SBO-401k agreement, be sure to ponder over your choices of the elections because you may well become ineligible to participate in your small business owner 401(k) plan if you make the wrong elections. Here are some examples when this could happen:

i) For e.g. if you have an age eligibility requirement of at least 21 years of age while you are only 20 years, you are basically excluding yourself from participating in the plan.

ii) For e.g. suppose you elect 0 hours of service before an employee becomes eligible to participate in your small business 401(k) plan. However you may overlook the other 3 part time employees that you have working for you that work on seasonal hours (less than 1000 hours a year) and are 21 years of age or older and thus eligible to participate in the small business 401(k) plan. If this happens, then you cannot set up a small business owner 401(k) plan.

Contributions to a Small Business Owner 401(k) Plan – Salary Deferral & Profit Sharing Limits

Contributions to a small business 401(k) plan can be made in the form of either salary deferral contributions or profit-sharing contributions.

i) Salary deferral contributions – The small business owner may make salary deferral contribution of 100% of his eligible compensation income up to a maximum limit of $16,500 for the year 2009.

ii) Profit-sharing contribution – The small business may contribute up to 25% of the owner’s compensation or 20% of the modified net profit for unincorporated businesses; up to a maximum of $49,000 for the year 2009.

Note that the $49,000 limit for the year 2009 includes both salary deferral contributions & profit-sharing contributions. Thus, a small business owner is not allowed to contribute $16,500 + an additional $49,000 to his small business owner 401(k) plan, this will result in the extra funds being distributed back to the small business owner.