401(k) option available to small-business owners

Timothy Reese is senior vice president, investments, with A.G. Edwards & Sons Inc.

In the past, small-business owners have not had many choices for retirement plans, and 401(k)s seemed too complicated and expensive. That is no longer the case. You may now be eligible for an owner-only 401(k) a relatively new option for small-business owners who would like to set up a retirement plan.

Any type of small-business entity, including partnerships and sole proprietorships, can participate in an owner-only 401(k) plan, as long as there are no other eligible employees except spouses. If you are an independent consultant, real estate agent or accountant, this may be a good retirement plan option.

The greatest advantage of an owner-only 401(k) is the contribution limit. With this type of plan, you are able to personally contribute up to $12,000 per year to your nest egg. In addition, you are also able to make contributions to your plan as an employer up to 25 percent of your total eligible salary. One thing to keep in mind is that your personal contributions and your employer contributions cannot exceed $40,000 in any given year.

Another benefit of owner-only 401(k)s is that they are eligible for the catch-up provision a provision that allows investors approaching retirement to make extra contributions. This means that in 2003, individuals over the age of 50 can contribute an additional $2,000 per year for a total of $14,000. Also, catch-up contributions are not included in the $40,000 limit, enabling you to contribute as much as $42,000 if you are eligible.

Let's take a look at an example of how an owner-only 401(k) compares with other popular retirement plans for small-business owners. Let's say you own an incorporated business and you earn $100,000 in salary this year. With an SEP-IRA plan, you would be able to contribute up to $25,000 toward your retirement savings. If you had a SIMPLE-IRA plan, you would only be able to contribute up to $11,000 annually. However, with an owner-only 401(k), you would be able to contribute up to $37,000 per year (25 percent of the $100,000 salary is $25,000 plus your personal contribution of $12,000) to your retirement fund, increasing the compounding power of your nest egg.

As you can see, you certainly stand to benefit from the higher contribution amounts. While these plans may be a bit more costly than an SEP-IRA or a SIMPLE-IRA because there are more tax-reporting requirements and they require an annual administrative fee, the ability to make higher contributions may make it more cost-effective.

Another benefit of an owner-only 401(k) is that all contributions are tax-deductible and can accumulate tax-deferred until withdrawn. Keep in mind, withdrawals prior to age 59 1/2 may result in a 10 percent penalty and are also subject to regular income taxes. In addition, contribution amounts are completely discretionary so you have the option each year to change or discontinue the contributions.

If you already have a regular 401(k) plan from a previous employer but are now self-employed, you are able to consolidate your assets into an owner-only 401(k) or you can roll over the assets into an IRA. In addition, if you are employed at a company that offers a 401(k) but you also own your own business, you may contribute to both plans, but certain limitations do apply.

There are many benefits to an owner-only 401(k), but the most important thing about any retirement plan is to begin saving as soon as possible. Your financial consultant can help you decide what the best retirement plan option is for you and your business.