Spring 2006
My-K: Saving for Retirement

If you’re like many self-employed business owners, you might assume a 401(k) retirement plan is out of reach. Or that your company just doesn’t qualify. Not so! There’s good news for the self-employed who want a tax-deferred retirement-savings plan that goes beyond an IRA. It’s the “My-K” plan, the nickname for the single-participant 401(k) plan.

Basically, a My-K plan works like a 401(k): money put into the plan from deferred salary or profit sharing isn’t taxed before it goes in, and isn’t taxed until you take it out as withdrawals after age 59Zx. Of course, there are rules and ins and outs, explained below; but that’s the gist.

Thanks to higher contribution limits, a My-K plan can make saving for retirement easier and faster. It’s easy to set up, and it costs less to start and maintain than you might think. More than 50,000 small-business owners have already plowed more than $3.7 billion in assets into their own My-K plans. And the plans are growing more popular every year.

The birth of My-Ks

My-K plans came into being thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). This act made changes to the rules and regulations governing many profit-sharing and retirement plans—changes that are very helpful to one- and two-employee businesses. Under EGTRRA, any business with no more than two employees—the entrepreneur/owner and his or her spouse only—can create its own 401(k) plan, or My-K. Businesses that can set up a My-K include sole proprietorships, S corporations, single-member LLCs, and partnerships (incorporated or unincorporated). My-K plans are easily set up by investment brokers, financial advisors or insurance agents with financial and investment expertise.

EGTRRA reduced most of the administration requirements for larger 401(k) plans, making My-K plans inexpensive to start and maintain. In addition, the new rules let plan participants make larger contributions to profit-sharing plans than they could under the old rules. These include “catch-up” contributions: plan participants 50 years old and up can make additional contributions without exceeding the previously established limits.

By the way, the My-K plan is also known by other names, including single-participant 401(k), self-employed 401(k), independent 401(k), solo 401(k), and Indy-K.

Plan funding

Under the My-K, you and your spouse make the choice every year as to whether to contribute to the plan or not, as you see fit. So if it’s been a lean year, you can decide not to put money into the plan that year.

Contributions (deposits) can come from two sources: salary-deferral and profit-sharing funds. Salary deferrals are amounts the employee earned but hasn’t actually been paid to the employee—instead they’re deposited into the My-K plan, usually through direct deposit. Deferred salary isn’t subject to taxes until you take it out of the My-K plan. Profit-sharing funds come from the company, and are contributed to the employee’s My-K plan account. These contributions, typically based on the net profit of the business, are usually made at the end of the calendar year. As with deferred salary, the plan participant doesn’t pay tax on these contributions while they remain in the My-K plan.

My-K Plans are typically funded once a year, on December 31st. But depending on how a business files its tax returns, funds from the two sources may be deposited at different times.

All contributions to the plan (up to certain limits) are fully tax-deductible as a business expense, and are tax-deferred—so no taxes are due until you make withdrawals from the plan after age 59Zx. At that time, withdrawals would be taxed as ordinary income. By the way, if you have funds in other “qualified” retirement plans such as IRAs, SEP IRAs and traditional 401(k)s, you can roll those funds directly into your My-K plan, again without paying tax on those amounts until you withdraw them.

A My-K plan also allows for loans and hardship withdrawals before age 59Zx. But check with your financial advisor first for rules, tax implications and other important details.

How much can you deposit into your My-K plan in a given year? That depends.

For deferred salary, you can contribute as much as 100 percent of your annual earned income, (salary, commissions, bonuses, etc.) up to $15,000 for 2006. If you’re age 50 or older, you can also put in up to $5,000 as a catch-up contribution in 2006. The maximum 2006 profit-sharing contribution is 25 percent of your annual net compensation, up to $220,000.

However, contribution limits take into account the tax-deductible profit-sharing contributions your business makes. For 2006, salary-deferral plus profit-sharing contributions can’t total more than $44,000. Catch-up contributions, however, don’t count toward the maximum.

Advantages

To fully appreciate the advantages of the My-K contribution structure, take a look at a My-K compared to the Simplified Employee Pension plan (SEP-IRA), another retirement plan that’s popular with small-business owners. The results below are based on a 50-year-old employee earning $100,000 and making the maximum contributions allowed in 2006:

SEP-IRA My-K

Maximum 2006 Made by contribution
Profit-sharing company $25,000 $25,000
Salary deferral employee not permitted $15,000
Catch-up employee not permitted $ 5,000
Total contributions for 2006 $25,000 $45,000

Under the SEP-IRA, it would take that employee 10 years to contribute $250,000 toward retirement, while under the My-K it would take less than six years. Clearly, the employee who fully contributes to a My-K plan will be in a much better financial position in the years to come than an employee fully contributing to a SEP-IRA.

Now take a look at some other advantages of the My-K, including investment options, taxes, plan administration and typical fees.

Investing plan assets

The total maximum contributions to the My-K in the above example is impressive—and it doesn’t even take investment earnings into account. And you get to decide how and where to invest the funds in your account. That’s because a My-K plan is a “self-directed profit-sharing plan”—pension-speak for the plan participant making the investment decisions.

For the most part, your investment options aren’t restricted: you can invest in any stocks, bonds or mutual funds you like. To choose or change where you want your plan funds invested, you’d simply do what you normally do for your personal investments: contact your broker or investment advisor, or make your investment arrangements directly by phone or online.

Tax advantages

My-K plans offer exceptional tax advantages. For an unincorporated business, contribution amounts are deducted from personal income. For incorporated businesses, they’re deducted as business expenses. Either way, the savings are substantial. For example, if a 50-year-old employee earning $100,000 makes the maximum salary-deferral contribution of $15,000 and the maximum catch-up of $5,000, and the company makes the maximum profit-sharing contribution of $25,000 (25 percent of $100,000), the employee’s taxable income would be reduced by an impressive $45,000.

Plan administration

My-K plans are easy to set up and easy to administer. At the end of the year, My-K participants receive a questionnaire from their plan administrator to make sure that the year’s contributions stayed within the legal limits, and that the company structure hasn’t changed such that the plan no longer meets IRS rules. For example, if more employees were added, the company no longer qualifies for a My-K plan. In that case, the plan would have to be terminated or rolled over into another retirement or profit-sharing plan that allows employees in addition to the original husband-and-wife team.

At the end of the year, the plan is also reviewed to determine if a Form 5500 must be filed with the IRS—Form 5500 must be filed if plan assets reach $100,000. If Form 5500 is necessary, the plan administrator will complete and file it.

Fees

My-K plans are less costly to administer than traditional 401(k) plans. Expect to pay a one-time charge of $250 to $750 for the legal documentation to initiate the plan. Once the plan is in place, plan administration costs range from $300 to $750 a year; the actual cost will depend on whether one or two employees participate, and if a Form 5500 has to be completed and filed.

Caveats

As with any profit-sharing plan, hardship withdrawals and loans to access funds before age 59Zx will have tax implications—meaning penalties. Penalties are based on when the funds are withdrawn, the amount withdrawn, and the reason.

Also, if the company grows and more employees are hired, a My-K plan will have to be converted into another type of plan and there will be costs associated with making those changes. Or if the employer goes bankrupt or otherwise ceases to exist, the plan will have to be terminated or rolled over into another qualified retirement plan to avoid early-withdrawal penalties.

A retirement plan of any kind is too important to approach casually. Pension planning is complicated, and for many specialty retail entrepreneurs, it’s uncharted waters. So it’s critical to understand how the plan works, what your options are, and the advantages and disadvantages before you take action. Don’t be afraid to ask questions: it’s in your best interest to understand the ins and outs. After all, it’s your money, and your future financial security, at stake.

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