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February, 2003 Tax Tip


Self-employed Can Benefit from a 401(k) Plan

For years, there wasn't much reason for a self-employed person to set up a 401(k) because it was costly and didn't offer any advantage over other retirement plans.  The  2001 tax law has changed that.

The self-employed can set up an individual or one-person 401(k) and potentially set aside thousands of dollars more a year in the tax-sheltered plan than what other retirement options allow.  The plan's flexibility allows the same or different amounts of pay to be contributed each month, and a contribution can even be skipped for a given month.  Many Investment companies have instituted individual 401(k)s, making them easier and less expensive to set up.

Despite its name, the individual 401(k) can cover more than one person, within strict limits.  The plan is designed for the self-employed person with no full- time workers except a spouse or other immediate family member.   It also works well for one or more partners, provided the partnership doesn't employ full-time people.

The law allows contributions of up to 25% of income plus the amount allowed for 2003 under regular 401(k)s, which is $12,000, up to a maximum this year of $40,000.  Thus, depending on income, contributions to a one-person 401(k) can be substantially higher than those other plans allow.

A small-business owner with an incorporated company and no employees who earns $100,000 can set aside 25%, or $25,000, plus $12,000 this year in an individual 401(k).  If the owner had a profit- sharing plan or Simplified Employee Pension used by many small businesses, the most he or she would be able to set aside is 25% of income, or $25,000.

The individual 401(k) is best suited for those who earn less than $160,000 if their businesses are incorporated.  For unincorporated sole proprietors, where the self-employment tax becomes part of the equation, the plan is suited for those with income of up to $210,000.  If income exceeds those levels, individuals might be better off with other plans.

As with conventional 401(k)s, contributions are made on a pretax basis. Ordinary income tax on principal and earnings is paid when the cash is withdrawn. Generally, a 10% penalty applies if the money is withdrawn before age 59 1/2.



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