Roth 401(k) 2006 Owner-only Plan

Considering the increases in the 401(k) maximum contribution and defined benefit pension benefit limits for 2006, a business owner who is old enough and earns adequate taxable earned income can contribute and deduct up to $194,600 into a combination of a defined benefit pension plan and profit sharing plan with a 401(k) feature. Adding and contributing to a Roth 401(k) option, in lieu of the pre-tax 401(k), lowers the deductible contribution to $174,600 but effectively increases the combined contribution to $225,369. Learn more about the 2006 limits

The following chart outlines the 2006 maximum contribution/benefit limits to an owner-only plan as compared to a SEP (Mini(k) Plan is a service mark of ERISA Expertise LLC and represents an optimally designed qualified retirement plan program for an owner-only business or a very small business (an employer with 1-10 employees):

Earned Income¹		$25,000	$50,000	$100,000	$116,000	≥$220,000
Age 25	Mini(k)	$21,250	$27,500	$40,000	$44,000	$70,000²
	SEP	$6,250	$12,500	$25,000	$29,000	$44,000
	Mini(k) Advantage	$15,000	$15,000	$15,000	$15,000	26,000²
Age 35	Mini(k)	$21,250	$27,500	$40,000	$44,000	$70,000²
	SEP	$6,250	$12,500	$25,000	$29,000	$44,000
	Mini(k) Advantage	$15,000	$15,000	$15,000	$15,000	$26,000²
Age 45	Mini(k)	$21,250	$62,500³	$110,000²	$117,600²	$117,600²
	SEP	$6,250	$12,500	$25,000	$29,000	$44,000
	Mini(k) Advantage	$15,000	$40,500³	$85,000²	$88,600²	$73,600²
Age 55	Mini(k)	$44,900³	$69,850³	$119,700²	$135,700²	$194,600²
	SEP	$6,250	$12,500	$25,000	$29,000	$44,000
	Mini(k) Advantage	$38,650³	$57,350³	$94,700²	$106,700²	$150,600²
¹Earned income is W-2 compensation net of deduction for employer plan contribution, or Self-
employment income net of deduction for 50% of FICA and plan contribution.
²Combination Mini(k) and Defined Benefit Pension Plans. Assumptions: GA94 Mortality, 5.5% Pre-
Retirement, 5.5% Post-Retirement; Normal Retirement Age is generally 10 years or age 62
dependent on age at start of plan.
³Requires higher total profit/income than assumed for SEP to fund Defined Benefit Pension Plan
© 2002-2006 ERISA Expertise LLC All Rights Reserved

How the Roth Option Increases Retirement Benefits (and effectively increases the contribution limit from $20,000 to $30,769)

Example 1: Same Net Pay Means Lower Roth Contribution A male participant is age 55 and earns $350,000 annually; however, for retirement plan purposes, his compensation is capped at $220,000 (the 2006 compensation limit). He pays taxes on his last dollars earned at the federal rate of 35% (his marginal tax rate, or MTR). He defers 9.1% of compensation, or $20,000, into a pre-tax 401(k) account. If he wants to have the same net pay after contributing to the Roth option, what is his after-tax Roth contribution? If he reduces his pay by the same gross amount of $20,000, he pays $7,000 in tax on the $20,000 (35%) and contributes $13,000 to the plan.

Example 2: Same Roth Contribution Means Higher Salary Reduction Same facts as the previous example except the participant contributes $20,000 to the Roth account. If the participant contributes the $20,000 maximum to the Roth account, what is his salary reduction? The participant reduces his pay by $30,679, pays $10,769 in tax (35%) and contributes $20,000 or $7,000 more in after-tax dollars to the Roth account than in the previous example.

Pay close attention to the $7,000 differential; it's key to understanding this puzzle.

Example 1 MTR Analysis: Let's first examine the prospective future changes in the participant's marginal tax rate (MTR) and their impact on his total after-tax retirement distributions resulting from 5 years of the $13,000 contributions to the Roth account compared to $20,000 contributions to the pre-tax account.

Graphic Illustration Assumptions 3% annual cost-of-living adjustments provide increases in the individual 401(k)/403(b) and catch-up limits each year through 2010 (subject to $500 minimum increments). Participant receives equal periodic payments for 15 years starting at age 71 payable over his life expectancy specified as age 85. The rate of return (ROR) for the 401(k) accounts are based on a portfolio of 60% stocks earning 8%, and 40% bonds earning 5.5%. The ROR for the side fund is based on a portfolio of 60% stocks earning 8% taxed annually at 15%, and 40% bonds earning 4% tax-free.

The analysis indicates that if the participant's tax rate is the same following retirement as it was when he made the contributions, both options provide the same total retirement benefit. If the participant's tax rate goes down, the pre-tax option was the right choice; if his tax rate goes up, the Roth was the right choice.

Example 2 MTR Analysis: Next let's examine the outcomes following retirement of $20,000 contributions to both accounts. As we determined, the $20,000 Roth contribution decreases the participant's paycheck by $30,769 as compared to the $20,000 contribution to the pre-tax account, which decreases his paycheck by only $20,000. However, to formulate a sound comparison of the $20,000 maximum contribution to the Roth versus a $20,000 maximum contribution to a pre-tax account, we must consider that it costs $10,769 more to contribute to the Roth. Therefore, we’ll invest the $7,000 after-taxes are paid on the $10,769 difference into an after-tax "side fund" savings account. The side fund benefits are combined with the pre-tax benefits and compared to the Roth benefits to formulate a sound comparison.

The outcome considering the side fund is not what one might suspect. The participant's outcome is better when selecting the Roth option even if his MTR decreases from 35% to 28%, and it is significantly better if his MTR remains at 35% or it increases to 42%.

The reason for this unexpected outcome is the participant's ability to invest in various asset classes within the tax-free Roth environment. Assuming comparable risk factors attributable to the selected investments, it is virtually impossible for a taxable side fund to perform as well as the tax-free Roth. For example, a very conservative after-tax investor might earn 4% in a tax-free bond; whereas, with a comparable level of risk, that same investor could earn 5.5-6% tax-free by investing in a taxable bond within the Roth environment.

As the chart above indicates, it is the establishment of a defined benefit pension plan and/or a plan with a 401(k) feature that permits a higher deductible contribution at any age or income level as compared to a conventional plan such as a SEP or SIMPLE IRA. However, what may not be apparent is that an owner-only "401(k)" plan (aka Solo 401(k) or Individual 401(k) plan) is a qualified retirement plan.

As the employer/plan sponsor of a qualified retirement plan, the owner-only business must comply with strict governmental guidelines to retain the plan's "qualified" status. And, believe it or not, these governmental guidelines are nearly as complex for a plan that provides benefits to an owner-only business as the ones that a company like Microsoft must follow. Failure to follow these rules may subject the plan to "disqualification" which means that all plan contributions and income on the plan investments may be retroactively taxable, and the business owner loses the ability to rollover the plan assets to an IRA at such time that he retires.

The key question that one should ask is: "Is this plan type appropriate for the individual's situation?" Meaning, does the business owner need/desire the higher tax deductible benefit that is gained by starting one of these plans versus a conventional plan. If a SEP or SIMPLE plan fulfills the business owner's needs (from a level of contribution/benefit perspective), he is typically better served using one of those plan types in that they require little if any governmental compliance.

Commentary The advent of the Roth 401(k) provides yet another opportunity for owner-only businesses to increase benefits at retirement and may be a valid consideration for stepping up to a 401(k) from a SIMPLE or SEP. If you are considering one of these plans for your clients, be mindful that once a SIMPLE plan is active for the 2006 plan year, no other plan may be established by that employer until 2007. And don't let anyone convince you that these plans are not complex to establish and administer. While the Roth provides additional benefits at retirement, it also adds another set of rules to follow to maintain compliance.

Ask yourself why many of the more savvy mutual fund companies like Vanguard and Fidelity, and investment vendors like Schwab have yet to offer standardized plans with the Roth feature? In fact, last we checked, Vanguard does not offer any ancillary services for owner-only plans (they do provide investment services for these plans).

We routinely represent small business owners with non-compliant plans who are subsequently audited by the IRS or Department of Labor. In most instances, these individuals have been misled into thinking that their plans did not require sophisticated compliance services.

You know the old saying: "You get what you pay for." It really does apply here, so proceed with caution and educate yourself before you recommend a low cost plan that leaves it up to the business owner alone to comply with all of the complex rules necessary to maintain their plan's qualified status. I can assure you that these clients wind up paying more to fix their broken plan than it would have cost to establish and administer it properly in the first place.

Bottom line The fees an owner-only business might pay to a competent pension compliance services provider are minimal compared to what may be lost by adopting an improperly designed and/or non-compliant plan.

2006 Owner-only Plan Limit Tops out at $194,600; $225,369 w/Roth Option - December 11, 2006