Small businesses can reap benefits from 401(k) plans

Before 2002, the most feasible retirement plans for small-business owners were SIMPLE or SEP individual retirement accounts. These were usually easier and less costly to establish and maintain than other qualified retirement plans. Now, thanks to recent changes in tax law, small-business owners can consider more retirement-plan options, including 401(k) plans.

Any type of business entity, such as sole-proprietorships, can participate as long as there are no other eligible employees except spouses. These plans may be a good option for self-employed individuals such as real estate agents, independent consultants, lawyers and accountants.

With the changes in the tax law, owner-only 401(k)s have become more appealing and cost-effective for small-business owners and their spouses because they are able to maximize their retirement savings efforts with higher contribution limits than are allowed with IRAs, SEPs and SIMPLE IRAs.

The biggest advantage of owner-only 401(k)s are the contribution limit changes. Before this year, your personal contributions (as an employee) were combined with your employer contributions (as a business owner) to make up your total annual contribution limit of 15 percent of your annual pay. Now, these contributions are separated, which means you can make personal annual contributions of up to $11,000 or $12,000 if you're over age 50 and use the new catch-up provision. Additionally, you can make employer contributions of up to 25 percent of your salary, not to exceed a combined total of $40,000.

To illustrate how these changes could affect you, let's say you own a business and you earn $100,000 in salary this year. In this instance, before 2002, the combined contributions were limited to $13,325. Now, though, you are able to defer as much as $11,000 of your salary to your 401(k) plan. In addition, your company could contribute up to $25,000 one-fourth of your annual salary to your 401(k) account for the same year for a total of $36,000. Keep in mind that if you're over age 50, that total will be $37,000 because of the catch-up contribution for which you are eligible.

If you have a 401(k) from a previous employer but are now self-employed, you are allowed to consolidate those assets into your owner-only 401(k) or you can roll them into a traditional IRA. Or, if you are employed at a company that offers a 401(k) plan but you also own your own business, you may contribute to both plans, although certain limitations do apply.

You'll want to set up your account as early in the year as possible so you can take advantage of a full year of tax deferral, just as you would with a standard 401(k). Also, owner-only 401(k)s function in basically the same manner as standard 401(k)s. While these plans may be a bit more costly than a SEP or SIMPLE IRA because there are more tax reporting requirements and they require an additional administrative fee, their ability to provide you higher contribution limits may make owner-only 401(k)s a cost-effective option.

(The preceding article was provided by Timothy M. Reese, vice president of investments with A.G. Edwards & Sons, member SIPC.)