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ROTH 401(k) and Solo 401(k) Plans

Starting in 2006, employers can allow employees to make their 401(k) contributions on an after-tax basis to Roth 401(k) accounts.

High income taxpayers should consider taking advantage of Roth 401(k)s for several reasons:

• The traditional expectation in retirement planning that individuals will be in lower tax brackets after retirement probably will not hold for many high income individuals.
• Contributing the maximums to a Roth 401(k) will result in larger net retirement savings.
• The greatest advantage is the ability to roll a Roth 401(k) into a Roth IRA which will NOT be subject to minimum distribution requirements after age 70 1/2. This can be a powerful estate planning tool in stretching tax-deferred payments over the lifetimes of children.

One negative with Roth 401(k)s is that EGTRRA (the 2001 tax legislation creating them) provided that they would not begin until 2006 and would, without further legislation, end after 2010. Nevertheless, this 5-year window could allow an individual at least 50 years old to contribute about $105,000 in those five years, which would likely grow significantly over many years of tax-deferred investment income.

SOLO 401(k)s or Uni(k)s

Until 2002, the 401(k) deferrals which an individual made to a plan were included in that plan’s total deductible limit of 15% of compensation. Starting in 2002, the 15% limit was increased to 25% and employee 401(k) deferrals no longer counted towards this 25% limit.

Self-employed individuals and their spouse whose businesses do not have any other employees can take advantage of these significant changes by adopting a Solo 401(k), sometimes called a Uni(k).

An individual could first make the maximum 401(k) deferral; $15,000 if you’re under age 50 or $20,000 if you’re age 50 or older. Then, the individual can make an additional profit sharing contribution of 25% of W-2 compensation (or 20% of net self- employment income).

For example, a 50-year old individual who is the sole employee in an S Corporation and whose W-2 compensation is $100,000 could contribute $20,000 to the 401(k) component of the Solo 401(k) and $25,000 (25% x $100,000) to the profit sharing component, for a total retirement plan contribution of $45,000.

One big caveat for Solo 401(k)s is that they only work when there are no employees, other than owners, principals, and spouses.

401(k) SAFE HARBOR PLANS

Employers who have continuing problems satisfying the discrimination testing for 401(k) plans might want to consider adding a Safe Harbor provision to their plans.

While the cost of fully vested Safe Harbor contributions of 3% of compensation may be prohibitive for many companies, there are several significant advantages for companies who can afford these contributions, including:

• No discrimination testing is necessary which:
  • Saves administrative time and expenses
  • Avoids refunding 401(k) contributions to highly compensated employees.
• Top heavy contribution requirements are satisfied by the 3% contributions.
• Up to an additional 6% may be contributed for principals and owners if the demographics of the company satisfy certain tests.

There are a number of complications and documentation issues involved with 401(k) Safe Harbor plans, but employers who can afford the 3% contributions should make a careful analysis to see if a Safe Harbor plan could work for them.

 

Article prepared by Paul Brennan of Boston Benefits Consulting in Concord, MA.
Information is as of January 2006.

Information in this material is for general purposes only. You should consult Sechrest & Bloom, LLC
at 978-263-7771 for specific recommendations about your particular situation.

This article was supplied or updated on October 4, 2005.