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Self-employed can benefit from 401(k)s under new law


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.

But, thanks to the 2001 tax law, that has changed.

Beginning this year, 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.

Investment firms, seeing the opportunity, have been launching individual 401(k)s this year, 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, said Barry Glassman, a financial planner in McLean, Va. It's also geared for one or more partners, provided the partnership doesn't employ full-time staffers.

New York benefits plan administrator Robert Fletcher runs his own business with the help of his wife. He heard about the individual 401(k) a few months ago and quickly set up one to cover both of them.

The 59-year-old said the plan will allow him to set aside $12,000 more a year than his previous plan permitted. And he said he likes the plan's flexibility - he can put in 10 percent of his pay one month, 20 percent the next or even skip contributions.

"It's very easy to set up and take care of," Fletcher said. "It helps you set a little more aside."

The new law allows contributions of up to 25 percent of income plus the amount allowed under regular 401(k)s, which is $11,000, up to a maximum this year of $40,000.

People 50 or older are eligible for the catch-up contributions permitted in 401(k)s - an additional $1,000 this year. That could put someone's total contribution at $41,000 for the year.

Depending on income, contributions to a one-person 401(k) can be substantially higher than those other plans allow.

For example, a small-business owner with an incorporated company and no employees who earns $100,000 can set aside 25 percent, or $25,000, plus $11,000 this year in an individual 401(k). If she's 50 or older, she can salt away an additional $1,000, for a total of $37,000.

If she had a profit-sharing plan or Simplified Employee Pension (SEP) used by many small businesses, the most she would be able to set aside is the 25 percent 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, Glassman said.

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, he said.

Once income exceeds those levels, individuals might be better off with other plans.

At that point, they would be able to put $40,000 in a SEP or profit-sharing plan. Both are less complex and might be cheaper to set up and maintain, Glassman said.

It also might not be worth the effort of establishing a one-person 401(k) if someone doesn't have much extra income, because the benefit of the plan is to maximize contributions, Glassman said.

"The question that individuals should ask themselves is, 'What will this do for my retirement? Can I afford today to put these additional dollars in?'" Glassman said. "Some people can't. Some people have college tuition payments."

The one-person 401(k) also might not be suitable for someone planning to expand the business soon and add full-time workers outside the immediate family.

Once that happens, the plan would have to be closed or converted to a regular 401(k) to include workers, experts said. A regular 401(k) is more costly and has more stringent reporting and testing standards. In addition, the employer's contributions can be restricted by how much lower-level workers put into the plan, experts said.

The individual 401(k) might not be for everyone, but many could benefit, experts said.

"There are 17 million self-employed individuals out there. This is really great news," said Marcia Mantell, vice president of Fidelity Retirement Services, which launched its Fidelity Self-Employed 401(k) last week.

Scudder Retirement Services created the Scudder Personal(k) early this year and says it has been well received and is gaining momentum.

"For the first time, they get a lot of the advantages of the 401(k), but at such a higher contribution limit," said Susan Hartnett, a Scudder vice president.

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 percent penalty applies if the money is withdrawn before age 59 1/2 .

The cost of establishing a one-person 401(k) varies. Some investment firms charge fees for setting up a plan and for annual maintenance. Combined, the fees can run as much as a few hundred dollars. Some investment firms don't charge set-up and maintenance fees for balances above a certain level.

Once an account reaches $100,000, an annual form must be filed with the Internal Revenue Service, which can cost someone an additional couple of hundred dollars.

If you go with a plan offered by an investment firm, compare the investment options, fees, features and restrictions. Scudder, for instance, permits 401(k) loans; Fidelity doesn't.

"The options to invest are probably the most important, because these are long-term investments," Glassman said. "You would want to make sure you have enough choices ... if you want to move to another area of the market."

To suggest a column idea, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@baltsun.com.

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