EDUCATION CENTER
GTT RESOURCES: STRATEGIES: RETIREMENT PLANS

Check out the new Mini 401K Plan.
Timely action on a retirement plan tax strategy before year-end can save you a bundle in taxes.

Here’s a 2003 tax savings idea!
Put $4,400 in your pocket simply by saving $13,632 for your retirement. Hire our firm to form a "GTT Mini 401(k) Retirement Plan" and a "GTT single-member LLC" (traders need an entity for a retirement plan). Before year-end, your LLC pays a fee of $17,500 to you, the manager. You then contribute $13,632 to your Mini 401(k) plan by Oct. 15, 2004 ($100 by year-end). Here are the details:

Here is a 2002 tax year example. You have Adjusted Gross Income (AGI) deductions in the amount of $17,284, comprised of the following:

$13,632 tax-deductible contribution to your Mini 401(k) plan;
the maximum 401(k) elective deferral amount of $11,000 for 2002 ($12,000 for 2003).
In addition, you are entitled to a profit-sharing contribution of 20 percent of your net fee income (after deducting 50 percent of your self-employment [SE] tax);

$2,415 of deductible health insurance premiums.
For 2002, you may deduct 70 percent of your health insurance premiums (up to your earned income). Starting in 2003, the 70-percent deduction rises to 100 percent of earned income;

$1,237– one-half your SE taxes of $2,473 due on your $17,500 fee income.

You save $6,914 in income tax savings, assuming a combined federal and state marginal income tax rate of 40 percent of the $17,848 AGI deduction.

You owe SE taxes of $2,473 ($17,500 fee income multiplied by 92.35 percent multiplied by 15.3 percent SE tax rate). All of your net earnings are subject to Medicare deductions – 2.9 percent of SE taxes.

Plus, you replaced "bad" income taxes with "good" SE taxes. Paying SE taxes increases your retirement benefits (social security and Medicare insurance); income taxes never benefit you in the future.

Your cost of forming the entity (needed for a trader retirement plan), including GTT's fees and state-filing fees, is around $750. In future years, you don't have this one-time cost. Click here to learn about our GTT Entity Formation Services.

If you have a very successful year and can afford to contribute more to your retirement plan, we recommend you contribute the maximum allowed – $40,000 (to a Mini 401(k) plan or other type of defined contribution plan). In that case, you can expect even greater net savings, and you'll be able to grow more money in a tax-deferred account.

The major tax reason why the Mini 401(k) is the most attractive retirement plan for traders is that you can contribute the maximum $40,000 on a lower fee income of $152,320. With other profit-sharing retirement plans, you must use the maximum fee compensation allowed of $200,000 to get close to the $40,000 contribution limit (or just less than $40,000, after deducting half the SE tax). With the Mini 401(k) plan, you save $1,383 in SE taxes – you pay SE taxes on $152,320 instead of $200,000.

If you are interested in this type of trader retirement savings plan, contact info@greencompany.com or call us.

We recommend our half-hour consultation for $125. Robert A. Green, CPA, will review your tax and retirement situation and to consult you on the best retirement plan for your needs. Sign up below.

Here are some brokerage firms offering Mini 401(k) plans. Their sites have useful information. We plan to add more links soon, as other brokers should be rolling out these products to meet demand in the marketplace. We don't have any alliances with the below companies nor do we get compensated in any way.

www.pioneerfunds.com/uni_k/benefits.jhtml
www.americancentury.com/workshop/articles/max_contribution.jsp
www.scudder.com/t/index.jhtml?content=/t/retirement/index.jhtml&document=scudderpersonalk.html
http://page2.tdwaterhouse.com/faq/faqdefault.asp?type=indiv
www.advest.com/individual/Individualk.htm

New "mini 401(k)" plans (from RIA).

How self-employed taxpayers may claim much larger deductions for retirement plan contributions on 2002 returns (from RIA)

Types of retirement plans.

2002 tax law changes effecting retirement plans.

IRS Publication 3998: Choosing a retirement solution for your small business.

IRS Publication 560: Retirement Plans for Small Business.

If you have any questions on retirement plans for traders, send us a confidential e-mail at info@greencompany.com or call us.

Consultation: 30 minutes with Robert A. Green, CPA $125 Consultation: 60 minutes with Robert A. Green, CPA $225

If you want to set up a GTT retirement plan along with a GTT Trader Entity, purchase the below service:

GTT Trader Entity Formation Service $400

After we form your entity and retirement plan, it is wise to engage our firm to prepare your 2002 tax returns, to make sure you execute this entire tax strategy correctly.

GTT Trader Tax Return Preparation Service $500

Types of retirement plans (RIA Client Letter)

If you've recently started a business, you may be considering setting up a qualified retirement plan for yourself and your employees. There are several different types of plans that can qualify for the tax advantages of a qualified plan—a current deduction from income to the employer for contributions to the plan, tax-free buildup of plan investments and the deferral of income (augmented by investment earnings) to the employees until distribution of the funds. The type of plan you choose will depend on your individual needs and circumstances.

There are two basic types of plans—the defined benefit pension plan, and the defined contribution plan. A defined benefit plan provides for a fixed benefit at retirement based generally upon years of service and compensation. Adoption of a defined benefit plan is a nondiscretionary commitment to fund the plan. These plans will often provide the greatest current deduction from income, and the greatest retirement benefit, where the owners of the business are older and nearing retirement.

A defined contribution plan is a plan that provides for an individual account for each participant with benefits based solely on the amount contributed to the participant's account and any investment income, expenses, gains and losses, and any forfeitures (usually from departing employees) that may be allocated to the participant's account. Profit-sharing plans are defined contribution plans, and can provide you with the flexibility of determining the amount of contributions to be made for a particular year.

A 401(k) plan, or cash or deferred arrangement, is a defined contribution plan, with employer contributions made at the direction of the employee under a salary reduction agreement. The employee elects to have a certain amount of pay deferred and contributed by the employer on his or her behalf to the plan. The employer may or may not provide matching contributions to the amount deferred, as provided for in the plan. This type of plan can provide tax-deferred retirement benefits for employees at little cost to an employer, beyond the costs of administering the plan.

These plans may also allow participants to make after-tax contributions to the plan, which can be invested tax free.

There are other types of plans within these general categories, including employee stock ownership plans (ESOPs) in which shares of stock in the employer are purchased to fund the plan.

Small businesses may adopt a “simplified employee pension” (SEP), and receive similar tax advantages to “qualified” plans by making contributions to SEP-IRAs on behalf of employees. A business with 100 or fewer employees may establish a “SIMPLE” (savings incentive match plan for employees) retirement plan . Under a SIMPLE plan, an IRA is established for each employee, and the employer makes matching contributions based on contributions elected by participating employees under a qualified salary reduction arrangement. Or, a SIMPLE 401(k) plan may be set up with features similar to a SIMPLE plan, with automatic passage of the otherwise complex nondiscrimination test for 401(k) plans.

We would be happy to discuss in greater detail the types of retirement plans available to you. Please call to set up an appointment.

© Copyright 2002 RIA.

For a much more detailed overview of types of retirement plans, see 2002 tax law changes effecting retirement plans, see below.

2002 tax law changes effecting retirement plans.

IRS Publication 3998 (7-2002)
CHOOSING A RETIREMENT SOLUTION for Your Small Business This pamphlet constitutes a small entity compliance guide for purposes of the Small Business Regulatory Enforcement.

New IRS pub describes retirement plan options for small businesses (reprinted with permission from RIA)
IRS Publication 3998
IRS has released a new publication, “Publication 3998: Choosing A Retirement Solution for Your Small Business,” which describes the retirement plan options available to small businesses.

Benefits of starting a retirement plan. The pub notes that, by starting a retirement savings plans, a small business can help its employees save for the future, help the business attract and retain qualified employees, offer tax savings to the business, and help secure the business owner's own retirement. As the publication explains, a retirement plan has significant tax advantages including the following:

contributions are deductible by the employer when contributed;
employer and employee contributions are not taxed until distributed to the employee; and
money in the retirement program grows tax-free.

Also, as IRS noted, recent tax law changes have provided additional incentives to start a retirement plan, including:

higher contribution limits so employees (and the owner) can set aside larger amounts for retirement;
“catch-up” rules that allow employees aged 50 and over to set aside an additional $500 (or $1,000, depending on the type of plan) for 2002;
a tax credit for small employers for part of the ordinary and necessary costs of starting a SEP, SIMPLE, or certain other types of plans. The credit equals 50% of the cost to set up and administer the plan, up to a maximum of $500 per year for each of the first three years of the plan; and
a tax credit for certain low- and moderate-income individuals who make contributions to their plans (“saver's tax credit”).

Plan choices. Small businesses may choose to offer IRAs, defined contribution (DC) plans, or defined benefit (DB) plans. Many financial institutions and pension practitioners make available one or more prototype retirement plans (i.e., 401(k) plans, profit-sharing plans, and money purchase plans) that have been pre-approved by IRS and can greatly lessen the administrative burden on employers.

RIA observation: The pub includes a chart outlining the advantages of each of the most popular types of IRA-based and DC plans and an overview of a DB plan. See page 4 of the PDF file.

Payroll-deduction IRAs. An employer can allow its employees to contribute to an IRA through payroll deductions. The decision about whether to contribute, and when and how much to contribute, to the IRA is made by the employee. Payroll deductions allow individuals to plan ahead and save each pay period, and are tax-deductible by an individual, to the same extent as other IRA contributions. The maximum annual contribution per participant is $3,000 for 2002—2004; $4,000 for 2005—2007; $5,000 for 2008. Additional contributions can be made by participants age 50 or over.

Simplified employee pensions (SEPs). A SEP allows employers to set up a type of IRA for themselves and each of their employees. Employers must contribute a uniform percentage of pay for each eligible employee, although they do not have to make contributions every year. Also, the business owner can decide how much to put into a SEP each year—offering flexibility when business conditions vary. Most employers can establish a SEP, which has low start-up and operating costs and can be established using a two-page form.

The maximum annual contribution per participant is the lesser of 25% of compensation or $40,000.

SIMPLE IRA plans. This savings option is for employers with 100 or fewer employees. A SIMPLE IRA plan allows employees to contribute a percentage of their salary each paycheck and requires employer contributions. Employers must either match employee contributions dollar for dollar—up to 3% of an employee's compensation—or make a fixed contribution of 2% of compensation for all eligible employees.

SIMPLE IRA plans are set up by filling out a short form, and administrative costs are low. Employers may either have employees set up their own SIMPLE IRAs at a financial institution of their choice or have all SIMPLE IRAs maintained at one financial institution chosen by the employer. Employees can decide how and where the money will be invested, and keep their SIMPLE IRAs even when they change jobs.

Employees can contribute up to $7,000 (for 2002) with $1,000 annual incremental increases until the limit reaches $10,000 in 2005. Additional contributions can be made by participants age 50 or over.

The employer can either (a) match employee contributions 100% of first 3% of compensation (can be reduced to as low as 1% in any 2 out of 5 years); or (b) contribute 2% of each eligible employee's compensation.

401(k) plans. With a 401(k) plan, employees can choose to defer a portion of their salary. These deferrals go into a separate account for each employee. Generally, the deferrals (plus earnings) are not taxed by the federal government or by most state and local governments until distributed. 401(k) plans can vary significantly in their complexity.

Employees can contribute $11,000 in 2002. This limit increases $1,000 each year until it reaches $15,000 in 2006. Additional contributions can be made by participants age 50 or over. The employer/employee combined contribution limit permits annual contributions per participant up to the lesser of 100% of compensation or $40,000. Employers can deduct their contributions up to 25% of aggregate compensation for all participants.

Profit-sharing plans. Employer contributions to a profit-sharing plan are discretionary, and there is often no set amount that an employer needs to contribute each year. If an employer makes contributions, it needs a set formula for determining how the contributions are allocated among plan participants. The funds go into a separate account for each employee. Profit-sharing plans can vary greatly in their complexity.

The maximum annual contribution per participant is the lesser of 25% of compensation or $40,000. Employers can deduct amounts that do not exceed 25% of aggregate compensation for all participants.

Money purchase plans. Money purchase plans are DC plans that require fixed employer contributions, which are specified each year in the plan document.

The maximum annual contribution per participant is the lesser of 25% of compensation or $40,000. Employer can deduct amounts that do not exceed 25% of aggregate compensation for all participants.

Defined benefit plans. Defined benefit (DB) plans provide a fixed, pre-established benefit for employees. Employees often value the fixed benefit provided by this type of plan, and can often receive a greater benefit at retirement than under any other type of retirement plan. Also, businesses can generally contribute (and therefore deduct) more each year than in DC plans. However, DB plans are often more complex and, thus, more costly to establish and maintain than other types of plans. Contributions are actuarially determined.

© Copyright 2002 RIA. All rights reserved.

Mini 401(k) plan allows some small business owners to maximize retirement plan contributions—part 1

Pamela D. Perdue

Prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), it was unusual for a single-employee company to establish a Section 401(k) plan. This was due to the fact that the owner of a company, of which he or she was also the sole employee, could achieve the same benefits simply by establishing a company pay-all profit sharing plan. In addition, the small employer had other plan options that resulted in less administrative cost, such as a SEP. Where the employee received relatively modest compensation, a SIMPLE IRA would often prove a preferable alternative.

As explained in this Practice Alert (Part one of two parts), changes resulting from the enactment of EGTRRA, however, have turned this analysis on its head.

What is a Mini 401(k)?
A Mini 401(k) plan is simply a Section 401(k) established by an employer having either one employee or a very small number of employees. Where the employer has only a single employee-owner, the Mini 401(k) is often referred to as a Solo 401(k) plan. Typically, where the company employs individuals other than the owner of the company, the other individuals are members of the owner's family.

The advantages of such an arrangement have been significantly increased as a result of changes made by EGTRRA. These changes allow a Mini 401(k) plan to be established to maximize the contributions for owners and their family members employed by the business without the additional costs traditionally associated with plans maintained for the benefit of rank and file employees. Moreover, because they are anticipated to be free from the nondiscrimination testing that normally applies to Section 401(k) plans, Mini 401(k) plans can be drafted and administered much more simply and cost effectively.

EGTRRA Changes Affecting the Decision
Three primary changes resulted from the enactment of EGTRRA that will require very small companies to reconsider the decision not to establish a Section 401(k) plan: (i) the increase in the maximum allowable elective deferral limit under Code Sec. 402(g) ; (ii) the increase in the Code Sec. 415(c) limit; and (iii) the increase in the maximum deductible contribution limit coupled with a change in the manner in which the limit is determined under Code Sec. 404 .

Increase in the elective deferral limit.

Prior to EGTRRA, the maximum amount that a participant could contribute for a calendar year on a before-tax basis to a Section 401(k) plan was based upon a base amount of $7,000. However, cost of living adjustments to this Code Sec. 402(g) limit had caused the base amount to increase to $10,500 for the calendar year beginning in 2001. Because increases were based upon cost of living adjustments, the limit had increased relatively slowly, with some years seeing no increase at all in the limit.

Under EGTRRA, the elective deferral limit is $11,000 for tax years beginning in 2002 ($12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006 or thereafter). Once the limit reaches $15,000, it will subsequently increase based upon cost of living adjustments in multiples of $500.

Moreover, this maximum deferral limit may itself be further increased by catch-up contributions. Participants who have attained age 50 before the close of a calendar year (or who are projected to do so) are allowed, post-EGTRRA, to make additional contributions under a Section 401(k) plan as catch-up contributions to help them to make up, in terms of their retirement savings, for those periods when the basic elective deferral limit is considered to have been unreasonably low. Catch-up contributions under Code Sec. 414(v) can be made by eligible participants as follows: $1,000 for years beginning in 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 or thereafter. This increased contribution can be made without running afoul of the Code Sec. 415 limit. Further, so long as a plan allows all similarly situated participants to make catch-up contributions, Code Sec. 414(v)(3)(B) provides that the additional contributions will not cause a plan to fail the actual deferral percentage test, that is, the special nondiscrimination test that applies to Section 401(k) plans.

Due to these increases, an employee participating in a Section 401(k) plan can now contribute, on a before-tax basis, $12,000 in elective deferrals for 2003. Moreover, if that employee is at least age 50, he or she can contribute an additional $2,000, thus resulting in a total before-tax contribution of $14,000 for 2003. This is $5,000 more than the maximum before-tax contribution that can be made to a SIMPLE IRA for the same period (i.e., $8,000 in elective deferrals plus $1,000 in catch-up contributions for a total before-tax contribution limit of $9,000).

Increase in the Code Sec. 415 limit.

The second change that made establishing a Mini 401(k) plan more attractive was EGTRRA's increase in the overall maximum Code Sec. 415 limit.

Effective for limitation years beginning in 2002 and thereafter, the maximum Code Sec. 415(c) limit, that is, the maximum amount of contributions from both the employer and the employee that can be made under an employer's defined contribution plans on behalf of a participant for a limitation year, increased from the pre-EGTRRA limit of the lesser of 25% of compensation or $30,000 (increased as a result of cost of living increases to $35,000), to the lesser of 100% of compensation or $40,000 (also scheduled to increase based upon cost of living increases). The increase in the maximum percentage limit from 25% to 100% has a significant potential impact on the establishment of a Mini 401(k) plan by those companies with only one employee where that employee is paid a relatively modest amount (i.e., under $40,000). This is because the sole employee-owner receiving annual compensation of less than $40,000 could receive a total aggregate contribution under a Mini 401(k) plan, taking into consideration both employee and employer contributions, of up to 100% of his or her before-tax compensation without running afoul of the Code Sec. 415 limit.

GTT Observation: Code Sec. 415 changes above speak of 100 percent of compensation or $40,000 as the "maximum amount of contributions" to a plan each year. It is very important to note that "maximum amount of contributions" does not also mean the same amount is tax-deductible. The next section talks about Code Sec. 404 tax-deductible limitations, which rise to 25 percent of compensation or $40,000 under the new tax laws. So if compensation is $40,000, 100 percent of the $40,000 may be contributed to a defined contribution plan, but only 25 percent of that $40,000 – $10,000 – is deductible. The taxpayer gets a $10,000 deduction, but has the opportunity to benefit from tax-deferred portfolio income on those retirement assets. This writer talks about the tax-deferred growth opportunity with the term "increase in the maximum elective deferral limit" below.

Changes to the deduction limit.

The changes in the maximum Code Sec. 415(c) limit coupled with the increase in the maximum elective deferral limit might still not have been enough to justify the potential additional costs of establishing a single-person Section 401(k) plan, particularly, when compared with lesser cost alternatives such as the SIMPLE IRA, absent EGTRRA's changes to the deduction rules.

Prior to EGTRRA, the maximum (tax) deductible contribution that a company could make to a profit sharing plan was limited to 15% of the total eligible compensation under the plan. This reflected the lowest deductible limit applicable to any tax qualified plan. However, EGTRRA amended Code Sec. 404(a)(3) to increase this limit to 25% of eligible compensation under the plan. Pursuant to the requirements of Code Sec. 401(k)(2) , a Section 401(k) plan must be part of an underlying profit sharing, stock bonus, rural cooperative, or pre-ERISA money purchase plan. Since the vast majority of Section 401(k) plans are part of an underlying profit sharing plan, the maximum deductible limit for such contributions has also increased, under EGTRRA, to 25% of aggregate participant compensation.

In addition to increasing this maximum limit, however, EGTRRA made an additional change to the maximum deductible limit that has even more significance for Section 401(k) plans. Specifically, EGTRRA added Code Sec. 404(n) , which provides that elective deferrals will no longer count towards this 25% limit. Thus, an employer is free to make a 25% contribution to a Section 401(k) plan without regard to the level of elective deferrals contributed by the company's employees. These changes make the Section 401(k) plan more attractive to the small owner-only company, including those whose companies provide additional part-time income, particularly where the owners may receive compensation significantly less than the $200,000 maximum compensation limit under Code Sec. 401(a)(17) .

Code Sec. 404(n) Elective deferrals not taken into account for purposes of deduction limits.
Elective deferrals (as defined in section 402(g)(3) ) shall not be subject to any limitation contained in paragraph (3) , (7) , or (9) of subsection (a) or paragraph (1)(C) of subsection (h) and such elective deferrals shall not be taken into account in applying any such limitation to any other contributions.

Advantages of the Mini 401(k) Plan
The EGTRRA changes result in the single most important advantage of the Mini 401(k) plan: its ability to allow single-employee owners, multiple owners, or owners and their families to maximize their contributions to a retirement plan. This is particularly important where recent stock market losses may have resulted in significant losses in retirement accounts.

RIA illustration : Leslie is the owner and sole employee of the ABC company. Leslie receives annual compensation from ABC of $20,000. Leslie would like ABC to establish a retirement plan and is considering both a company pay-all profit sharing plan and a profit sharing plan with a Section 401(k) feature.

If ABC establishes a profit sharing plan without a Section 401(k) feature, the maximum deductible contribution that can be made to the plan is $5,000, that is, 25% of Leslie's compensation of $20,000. However, if the plan includes a Section 401(k) feature, that is, a Mini 401(k) plan, in addition to the $5,000 contribution from ABC, Leslie could contribute, for 2003, on a before-tax basis, up to $12,000. Leslie's before-tax contributions do not count towards the 25% deduction limit. The total contribution of $17,000 ($12,000 in before-tax contributions plus $5,000 of company contributions) do not exceed Leslie's Code Sec. 415 limit of $20,000 (that is, 100% of Leslie's compensation determined before the reduction for before-tax contributions).

If Leslie is at least 50 years old, she could contribute, for the 2003 calendar year, an additional $2,000 of before-tax contributions as catch-up contributions.

Since Leslie, the sole owner, and therefore a highly compensated employee under the rules of Code Sec. 414(q) , is the sole employee, the plan will automatically satisfy the coverage and nondiscrimination requirements that apply to Section 401(k) plans.

If Leslie's goal is to maximize her retirement savings, the benefits of adding a Section 401(k) feature far outweigh the advantages of a company pay-all profit sharing plan, or a SEP or SIMPLE IRA.

The illustration assumes that Leslie's sole occupation is running ABC. If Leslie were employed by another company that also maintained a 401(k) plan (and she is under age 50), her combined 2003 pre-tax contribution to both plans could not exceed $12,000.

Pamela D. Perdue is of counsel to Summers, Compton, Wells & Hamburg in St. Louis, Missouri. She is the author of “Qualified Pension and Profit-Sharing Plans,” published by Warren, Gorham & Lamont. She is also the Chair of the ALI-ABA Fundamentals of Employee Benefits course.

© Copyright 2002 RIA. All rights reserved.

Mini 401(k) plan allows some small business owners to maximize retirement plan contributions—part 2

Pamela D. Perdue

Last week's Practice Alert explained the statutory changes that make the mini 401(k) plan a powerful retirement plan tool for smaller businesses. This week's Practice Alert carries part 2 of this article. It illustrates how the mini 401(k) plan can benefit a husband-and-wife team that runs a small business, and explains drafting and other issues that arise with such plans, including ERISA rules.

It is not only the single-employee company that may benefit from the establishment of a Mini 401(k) plan. Couples may also find that such a plan makes sense in their retirement and tax planning.

Prior to EGTRRA, many couples decided that only one spouse would be placed on the payroll of the family business. The other spouse might provide some benefits to the company, but not of a sufficient nature to justify a significant salary. For example, the other spouse might provide only part-time services. In such cases, it was often determined that the additional costs of such things as Medicare and Social Security taxes would far outweigh the relatively modest retirement benefit that could be accumulated with respect to a relatively modest salary where the Code Sec. 415 limits under a qualified plan would restrict the maximum contribution to 25% of compensation. Again, this decision may require rethinking as well due in significant part to the increase in the Code Sec. 415(c) percentage limit.

RIA illustration : Widget Co. is owned 100% by Chris who is paid annual compensation in excess of $200,000. Chris is married to Pat who has always provided part-time office help on an unpaid basis. This decision was made due to the tax costs (Medicare and Social Security) of providing a salary to Pat.

In 2003, after reviewing EGTRRA, they decide that Pat would start receiving an annual salary of $25,000. If Widget Co. establishes a Section 401(k) plan, both Chris and Pat could elect to defer $12,000 as before-tax contributions. Moreover, since the post-EGTRRA Code Sec. 415(c) limit has been increased to the lesser of $40,000 or 100% of Code Sec. 415(c) compensation, the only practical limitations on maximizing Pat's contributions are the maximum deduction limit of 25% and the 100% of compensation Code Sec. 415(c) limit. This means that, not counting the elective deferrals totaling $24,000, the maximum deductible profit sharing contribution that can be made to the plan is $56,250, that is, 25% of ($200,000 + $25,000). A profit sharing contribution of $28,000 is allocated to Chris, thus providing a total allocation to Chris of $40,000 ($12,000 in elective deferrals and a company profit sharing contribution of $28,000). A profit sharing contribution of up to $13,000 could be allocated to Pat so that Pat receives a total contribution of $25,000 ($12,000 in elective deferrals plus $13,000 in a company profit sharing contribution) without running afoul of either the Code Sec. 415 limits or the deduction limits of Code Sec. 404 . Since both Chris and Pat are highly compensated participants (Pat by virtue of the spousal attribution rules that apply when a spouse is a more than 5% owner), it is of no consequence that Pat receives a higher profit sharing contribution allocation than Chris.

In the alternative, Pat might decide not to maximize elective deferrals, in which case Pat would receive a larger company profit sharing contribution, subject again, to Pat's 100% of compensation Code Sec. 415 limit and the deduction limit of Code Sec. 404 .

Employers considering the establishment of a Mini 401(k) plan will likely wish to compare its benefits with the benefits that can be gained from establishing a SEP, a SIMPLE IRA, or a company pay-all profit sharing plan. The following table provides a breakdown, at various compensation levels, of the maximum deductible contributions that can be set aside under each plan type for the calendar year beginning in 2003:

These figures do not include any catch-up contributions for eligible participants.

Issues to Watch

Is a Mini 401(k) permissible?

There is nothing in the governing guidance that precludes the maintenance of a Section 401(k) plan for a single employee. Moreover, Reg. § 1.401(k)-1(b)(2)(i) , in its flush language, specifically provides that an arrangement will not be deemed to fail to satisfy the coverage and nondiscrimination tests applicable to Section 401(k) plans merely because all eligible employees are highly compensated.

Drafting and administrative issues.

The Mini 401(k) plan will prove useful where a small employer has no non-highly compensated employees. The document is generally drafted with the assumption that the goal is to maximize contributions and that there will not be any eligible non-highly compensated employees. Further, the actual administration of the plan is likely to be established as a low cost turnkey approach requiring little, if any, professional administration and no nondiscrimination testing.

However, care should be taken in both the drafting and the administration of the plan to deal with the potential that the business may grow and non-highly compensated employees may in fact one day become eligible to participate in the plan. Where the plan has been drafted to ensure maximum contributions, by such devices as a significant mandatory match, the employer will want to ensure that these issues are discussed, and that appropriate plan language is included, before any non-highly compensated employees become eligible. Otherwise, the employer may find itself obligated to make significant contributions for unanticipated participants.

Other laws—including employer aggregation rules.

Other rules that apply to traditional Section 401(k) plans continue to apply to a Mini 401(k) plan as well. This means, for example, that an employer that is part of a controlled or affiliated service group under Code Sec. 414(b) , (c), or (m) must continue to take into consideration employees of those related entities for purposes of determining whether the Mini 401(k) satisfies the applicable qualification requirements, including the minimum coverage requirements.

Similarly, ERISA's plan assets rules apply to Mini 401(k) plans as well. Department of Labor regulations govern at what point participant before-tax contributions to a Section 401(k) plan become plan assets. At the point that they become plan assets, should they fail to be deposited in trust, the plan fiduciaries risk both a breach of fiduciary duty as well as a prohibited transaction. The regulations do not provide an exception for elective deferrals withheld from the pay of owners of the company and/or from their family members.

Under Labor Reg. 2510.3-102 , employee contributions to a Section 401(k) plan become plan assets as of: the earliest date on which such contributions may reasonably be segregated from the employer's general assets, but in no event later than the 15th business day of the month following the month in which the contributions are received by the employer or, in the case of amounts withheld from wages, would otherwise have been payable to the participant. For a small plan (generally, a plan with fewer than 100 participants) with a single payroll system, the Department of Labor views these regulations as requiring the deposit of elective deferrals within days of the payroll (DOL auditors have stated, no more than seven days after the payroll).

Summary
The Mini 401(k) provides an additional and effective avenue by which small employers, including single-employee entities, may provide significant retirement savings for their employees. The Mini 401(k) provides significantly greater deductible contributions than the SEP or the SIMPLE IRA, particularly for those employees at moderate income levels. Notwithstanding their size and relative simplicity, however, these plans require care in drafting, and their administration should be monitored to ensure that they continue to meet the needs of the plan sponsors and covered employees.

Pamela D. Perdue is of counsel to Summers, Compton, Wells & Hamburg in St. Louis, Missouri. She is the author of “Qualified Pension and Profit-Sharing Plans,” published by Warren, Gorham & Lamont. She is also the Chair of the ALI-ABA Fundamentals of Employee Benefits course.

© Copyright 2002 RIA. All rights reserved.

How self-employed taxpayers may claim much larger deductions for retirement plan contributions on 2002 returns

Thanks to changes made by the 2001 EGTRRA, self-employed taxpayers may claim much larger deductions for retirement plan contributions on 2002 returns than they could for previous years. In fact, by combining a profit-sharing plan with 401(k)-style elective deferrals, some taxpayers may be able to put away and deduct their entire net self-employment income.

How it works. Larger retirement plan deductions for self-employeds are created by the following changes, all effective for years beginning after 2001:

(1)Elective deferrals (maximum of $11,000 for 2002) are no longer subject to the deduction limit that applies to profit-sharing plans (as well as salary-reduction SEPs). ( Code Sec. 404(n) ) Also, elective deferrals aren't taken into account when figuring the amount that's deductible for non-elective contributions.
(2)The maximum deduction for a self-employed's contribution on his own behalf to a profit-sharing or SEP plan is the lesser of 20% of net earnings from self-employment or $40,000 (previously it was the lesser of 13.0435% of net earnings from self-employment or $35,000). ( Code Sec. 415(c)(1) , IRS Publication 560, 2002, pg. 4 )
(3)A self-employed who is age 50 or older can make an additional catch-up contribution of $1,000 (for 2002). The catch-up contribution isn't subject to the deduction limits that apply to elective or regular contributions. ( Code Sec. 414(v)(2)(B) )
Two examples show how potent these rules can be.

Example (1). John Doe works full time for an apparel company earning $70,000 a year. But he also works as a graphic artist on the side, producing logos, brochures and other corporate art-work for small businesses. For 2002, John's net earnings from self-employment (sideline income minus related business expenses, minus the deduction for one-half of self-employment taxes paid) is $10,000. If John has a combined profit-sharing and 401(k) (cash-or-deferred) arrangement, he can put away and deduct the entire $10,000 of net earnings, consisting of:

(1)profit-sharing contribution (20% of $10,000 of net earnings from self-employment) = $2,000.
(2)Amount contributed under the 401(k) arrangement. This is the least of: (a) net profits from the business after making the profit-sharing contribution ($10,000 - $2,000 = $8,000); (b) $40,000 less the regular $2,000 profit-sharing contribution = $38,000; or (c) the maximum regular deferral amount ($11,000 for 2002). The least of these three figures is $8,000.
(3)Total deduction: $10,000.
The deduction worksheet at page 22 of IRS Publication 560, 2002 confirms that John Doe can claim $10,000 on line 31, Form 1040 (self-employed SEP, SIMPLE, and qualified plans) as an adjustment to arrive at AGI.

For federal income tax purposes, John's taxable income from the sideline business is thus reduced to zero.

RIA observation: Keep in mind that annual maximum 401(k) deferral amount ($11,000 for 2002) applies to all plans the taxpayer participates in. Thus, if John makes an elective $8,000 contribution to a 401(k) plan maintained by his full-time employer, the maximum he could put away in his own plan would be $5,000 (regular profit-sharing contribution of $2,000 plus $3,000 (which is the 401(k) overall dollar limit of $11,0000 for 2002 less $8,000).
Example (2). Mary Smith works full time as a manager for a cosmetics company but operates a side business as a marketing consultant. In 2002, she earns $50,000 from her full-time job and $70,000 from self-employment (her sideline income minus related business expenses, minus the deduction for one-half of self-employment taxes paid). If Mary has a combined profit-sharing and 401(k) (cash-or-deferred arrangement), she could put away and deduct $25,000, consisting of:

(1)profit-sharing contribution (20% of $70,000 of net earnings from self-employment = $14,000).
(2)Amount contributed under the 401(k) arrangement. This is the least of: (a) net profits from the business after making the profit-sharing contribution ($70,000 - $14,000 = $56,000); (b) $40,000 - the $14,000 regular profit sharing contribution = $26,000; or (c) the maximum regular deferral amount ($11,000 for 2003). The limit in (c) ($11,000) is the least of the three.
(3)Total deduction: $25,000.
If Mary is age 50 or older she could make an additional deductible catch-up contribution of $1,000 for 2002, for a total deductible contribution of $26,000.

As in the first example, keep in mind that annual maximum 401(k) deferral amount ($11,000 for 2002) applies to all plans the taxpayer participates in. Thus, if Mary also makes an elective $8,000 contribution to a 401(k) plan maintained by her day-job employer, the maximum she could put away in her own plan would be $17,000 (regular profit-sharing contribution of $14,000 plus $3,000 (which is the 401(k) overall dollar limit of $11,000 for 2002 less $8,000)). She could put away an extra $1,000 if she is age 50 or older.

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