How it Works

The law changes that made the Individual(k) plan possible did not explicitly create a completely new type of business retirement plan. Instead, what the new laws did was make a number of changes to the rules governing 401(k) plans that made them more attractive to certain small business owners. Prior to the passage of pension reform, there was no practical reason to use a 401(k) plan for an owner-only business since they could receive the same or greater benefits with less expense by establishing a profit sharing or money purchase plan. However, there are some very compelling reasons for certain small business owners to consider Individual(k) plans, chief among them, to maximize retirement savings.

Following is a brief summary of the major law changes that gave rise to the Individual(k) plan.

Deductibility (IRC Sec. 404)
Pension reform not only increased the percentage of compensation that could be contributed to profit sharing plan and deducted from income from 15 percent to 25 percent, it also changed the rule that deferrals had to be added to profit sharing contributions for the purpose of determining the maximum deductible contribution. The table below compares the difference in what a person with $100,000 in annual W-2 income can contribute to a 401(k) plan both pre-and post-pension reform.

Maximum Deductible 401(k)   Contribution (2001)  Maximum Deductible Individual(k)   Contribution (2010)  $16,500 deferral ($22,000 if age 50 or older)   $15,000 total contribution*   $25,000 profit sharing contribution (25% of compensation)   $41,500 total contribution ($47,000 if age 50 or older)

*Prior to 2002, the deductibility limit considered both deferrals and profit sharing contributions. Furthermore, deferrals reduced compensation that could be considered for plan contribution purposes. For example, a person with compensation of $100,000 could not defer $15,000 because they would technically only have eligible compensation of $85,000 ($100,000-$15,000). A $15,000 deferral, therefore, would represent more than 15 percent of their eligible compensation.

Under the old deductibility rules, an owner could contribute 15 percent of compensation to a regular profit sharing plan without a 401(k) feature, so there was no incentive to add a 401(k) component to a profit sharing plan. In fact, under the old laws, a person potentially reduced the maximum amount they could contribute to a plan by deferring. To add insult to injury, 401(k) plans were also more expensive to operate.

Now, not only can a person make larger deductible contributions to a profit sharing plan than they could prior to pension reform, they often can put more into an Individual(k) plan than they can into a profit sharing plan with no 401(k) component.

Maximum Annual Contribution (IRC Sec. 415)
Federal law limits the amount that can be contributed per year to a single participant in a profit sharing plan. This limit takes into account all contributions made to an individual's account during a year, including deferrals, profit sharing contributions, and forfeitures. The table below compares the maximum amount that could be contributed to a 401(k) plan both pre- and post-pension reform.

Maximum Annual 401(k) Contribution (2001)   Maximum Annual Individual(k) Contribution (2010)   Lesser of 25% of compensation or $30,000*   Lesser of 100% of compensation or $49,000   ($54,500 if age 50 or older)

*Although the annual additions limit in 2001 was the lesser of 25% or $30,000, an owner who was the sole participant in a 401(k) plan could not save more than $25,500 in 2001, because they were limited to 15% of compensation for deductibility purposes, and because the compensation cap (the maximum amount that can be considered as compensation) in 2001 was $170,000. A person in an Individual(k) plan could make the maximum contribution of $49,000 ($54,500 if age 50 or older) with W-2 compensation of $118,000 or more. In addition, the compensation cap for 2010 is $245,000.

©2010 Ascensus, Inc., Brainerd, MN