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Changes enacted under the Economic Growth and Tax Relief Reconciliation Act of 2001(EGTRRA) have made it advantageous for small business owners who have no common law employees (other than a spouse) to set up a 401(k) plan. One-person 401(k) plans, which are often referred to in the financial press as “solo 401(k),” or “individual 401(k)” plans, allow a sole owner to make greater tax-deferred and tax-deductible contributions than would be permitted under a SEP or SIMPLE plan, without facing the complex nondiscrimination testing associated with large 401(k) plans.

Solo 401(k) Basics

401(k) plans are basically cash or deferred arrangements under which eligible employees make an election to either receive current compensation or to defer compensation by having their employer contribute a portion of their salary to a qualified profit-sharing or stock bonus plan. These plans originated around 1980 and have become the dominant feature of most employer-sponsored retirement plans. The elective deferral is not included in the participant’s gross income and the amount contributed to the underlying plan is not subject to current income taxation. Earnings on the account funds remain tax deferred until distributed. The current final regulations do not deal with the application of the 401(k) rules to situations involving a sole owner. However, proposed IRS guidance issued in July 2003 provides specific authorization for sole  owner 401(k) plans. The proposed rules state that, “generally, a partnership or sole proprietorship is permitted to maintain a cash or deferred arrangement and individual partners or owners are permitted to make cash or deferred elections with respect to compensation attributable to services rendered to the entity, under the same rules that apply to other cash or deferred arrangements”2 (emphasis added). The current final regulation mentions partnerships, but not sole proprietorships. Since a 401(k) plan must be part of an underlying profit-sharing plan or stock bonus plan, it is considered a “qualified” plan under Code Sec. 401. Accordingly, assets in a 401(k) plan, including a one-person plan, must be held under a written trust and the plan must meet minimum distribution requirements and make certain annual filings with the government. In addition, 401(k) plans are subject to certain special rules governing the amount of annual elective deferrals. The impact of these rules on one-person 401(k) plans is discussed in depth below. 401(k) plans are also subject to complex nondiscrimination requirements that are designed to ensure that such plans do not impermissibly favor highly compensated employees by allowing them to defer a larger amount of salary or receive greater matching contributions than lesser paid employees. However, these nondiscrimination rules would not come into play in a one-person plan with no employees.

What Do We Do

Fox, Lalonde & Kenne will prepare the Plan and Trust document for the Solo 401(k) plan sponsor as well as preparing certain ancillary documents that can be utilized in conjunction with the plan.

The Plan and Trust document is the Fox, Lalonde & Kenne Prototype Standardized 401(k) Profit Sharing Plan document. The Plan and Trust document is pre-approved by the Internal Revenue Service and a copy of the Favorable Determination Letter is included with the Plan documentation.

Future updates to the plan will be available through our website. Future Amendments to the plan will be made on the “Prototype Sponsor Level” and copies of those amendments will be available through our website.

Process

In order to initiate the Solo 401(k) Plan, the Plan sponsor must complete the Fox, Lalonde & Kenne Solo 401(k) Application Form and forward the executed form to our office. After reviewing the application, we will prepare the adoption agreement for the plan and email the document to the plan sponsor for review. If the provisions of the adoption agreement are correct, the plan sponsor will forward to us the $375.00 fee and we will then prepare the Plan Binder containing the necessary documentation to establish the plan.

Once the plan sponsor receives the plan documentation, they have the responsibility to establish the body of the trust, apply for the plan’s tax ID number and administer the plan. This plan is self-administered, Fox, Lalonde & Kenne is not the plan administrator or the plan contract administrator. The Plan Sponsor assumes all responsibility in administering this plan.

Administration of the Plan

The Solo 401(k) plan is a qualified retirement plan and as such must adhere to the provisions of the Internal Revenue Code (and accompanying regulations) governing qualified plans. If you have any questions regarding the administration of this plan, please contact a professional qualified plan administrator before proceeding.

Fox, Lalonde & Kenne assumes that the plan will be administered by a plan sponsor. The following are examples of administrative services:

  1. In-house administration
  2. Bundled administration
  3. Third-party providers
  4. Fully electronic plan administration supported by an outside vendor

The 401(k) recordkeeping marketplace changes rapidly, so the way services are packaged and offered is in constant flux, but the fundamental considerations for selecting a service provider remain relatively constant.

Advantages of in-house administration of a 401(k) plan

One major advantage is control over the original source data. The employer always maintains certain basic employee information in individual human resources files: name, Social Security number, date of birth, date of employment, and pay information. If this information is passed on to a third party, updates or changes must be handled twice: once by the employer and once by the third party. As a result, errors can occur. The employer also has easiest access to information about the other benefit plans it provides for its employees, making the coordination between plans much simpler. Moreover, an employer who is concerned about the confidentiality of data may be reluctant to pass information on to a third party. This data control advantage has been somewhat diluted in recent years, as many third-party providers can now access data directly from employers’ payroll service providers.

Disadvantages of in-house administration of a 401(k) plan

Outside recordkeepers have both the expertise and resources to keep abreast of changes in the law. In-house benefit administrators generally have other responsibilities and less ability to assess the impact of these changes on the recordkeeping system, since 401(k) administration will not be the employer’s primary business focus. The employer also may find this to be the most expensive option; outside legal and consulting resources need to be retained and consulted with on a regular basis. In addition to the compliance issues faced by in-house administrators, the increasing use of technology in servicing 401(k) plans makes it more difficult for in-house administrators to offer the types of services and features that many participants want. Features such as daily accounting, investment processing via telephone, Internet access to plan information and transaction activity, and on-line investment advice are often too expensive for an individual employer to invest in.

Advantages of bundled 401(k) administration

When both the investment management and recordkeeping services are provided at the same place, there is no need to rely on outside parties (other than the employer) for information. The financial institution will have the information necessary to prepare participant statements when it receives payroll data from the employer. Since the financial data are readily available, more frequent reports may be provided to participants than in-house administrators could provide. Some of the larger bundled 401(k) administrators have been in the business for many years and have considerable expertise. One key advantage of a bundled package is often cost, since the packages are frequently designed to reduce or eliminate direct costs by paying administration costs through investment management fees.

Disadvantages of bundled 401(k) administration

The primary disadvantage is that the employer may not be pleased with the performance of the bundled administrator in all respects. For example, if the investment performance is poor, the employer will have to choose a different administrator to provide employees with different investment opportunities. Similarly, if the employer is pleased with the investment performance but not with the timing of delivery of participant statements, the employer will have to seek another administrator and a new set of plan documents. In some cases, the bundled administrator may subcontract for the recordkeeping functions, and this may delay the delivery of reports. Moreover, a financial institution’s motivation in establishing bundled services often is to manage the assets of 401(k) plans. The administration of 401(k) plans may not be its primary business. It also may be difficult for the employer to ascertain the true cost of administration since certain loads or contract charges may be built into the insurance or investment contract.

Advantages of using a third-party provider for a 401(k) plan

If the employer is dissatisfied with the services of the provider, it is not necessary to disrupt the plan investments or plan documents. Similarly, the recordkeeping will not be disrupted if plan investments are changed. Like bundled administrators, most established providers have been in the 401(k) administration business for many years. In fact, many providers have worked with defined contribution plan administration since the passage of ERISA in 1974. Thus, providers have considerable expertise. Administration is generally their only business. A relatively new development in 401(k) daily recordkeeping is for providers to outsource high-volume transaction and technology-driven activity while the provider maintains compliance, customer service, and other people-dependent services. The theory is that the customer receives the best of both worlds—cutting-edge technology at reasonable cost and competent compliance work.

Disadvantages of using a third-party provider for a 401(k) plan

Processing delays may occur, since providers must wait for participant data from the plan sponsor and financial data from the investment adviser or trustee. Also, the provider must rely on the data provided by other parties, increasing the possibility for error to be introduced in the process. Finally, unlike a bundled administrator, a provider cannot easily provide reports more frequently than monthly. Many of these problems can be avoided if the provider is in a strategic alliance with the trustee or other party responsible for providing financial data or if the plan uses a daily valuation system.

Advantages of using fully electronic 401(k) plan service

The main advantage is cost. Plan sponsors can often get access to a broad range of 401(k) plan services, including Internet access for participants, at less cost than they would incur if those services were purchased from a vendor offering “people” supported services.

Disadvantages of using fully electronic 401(k) plan service

One disadvantage is that the plan sponsor bears substantial responsibility for data input. Another disadvantage is that a 401(k) plan may be too complicated for some plan sponsors to handle without consultative support on a regular basis.

Loans

Elective deferrals held in a 401(k) plan may not generally be distributed prior to a stipulated event, such as death, disability, hardship, retirement, or severance from employment. Hardship distributions are permitted where (1) the participant has an “immediate and heavy financial need” and (2) other resources are not reasonably available to meet that need. Loans—many 401(k) plans contain a provision that allows participants to borrow against their account balances prior to the occurrence of a distributable event. Such a provision can be made a part of a one-person 401(k) plan and thereby provide the owner-employee with a way to access funds in the account. The Internal Revenue Code imposes restrictions on plan loans that are designed to ensure that loans are true loans and not disguised distributions. First, the loan must be evidenced by a legally enforceable agreement that specifies the amount of the loan, the term of the loan, and the repayment schedule. It must also bear a “reasonable rate of interest.” Regulations under ERISA state that a loan bears a reasonable rate of interest if the plan is provided with a return commensurate with interest rates charged by commercial lenders. Second, the amount of the loan cannot exceed the lesser of (1) $50,000 (reduced by any previous outstanding loans) or (2) the greater of one-half of the present value of the participant’s nonforfeitable accrued benefit under the plan or $10,000. If the amount of the loan exceeds this limit, it is treated as a taxable distribution. Third, the loan must be repaid within five years or it is treated as a taxable distribution. There is one exception to the five-year repayment requirement. The five-year repayment requirement does not apply to any loan that is used for the acquisition of a dwelling unit that will be used as the principal residence of the participant within a reasonable time. (Refinancings do not generally qualify as principal residence loans). Fourth, the loan must be amortized on a substantially level basis and payments (principal and interest) must be made no less frequently than quarterly over the term of the loan. Loans that do not meet the above requirements are considered “deemed distributions” and subject to current income tax. In addition, if the participant has not attained age 59½ or is not otherwise entitled to an early distribution, the 10% additional tax on early distributions will be assessed.

Investments

Investment policies need to be flexible enough to adapt to an employer’s specific situation and reflect the fiduciaries’ attitudes and philosophies. For a typical 401(k) plan that allows participants a choice among investment funds, the policy should also recognize the participants’ needs and goals. Further, the policy should deal with the number and types of funds to be made available. How many choices are enough? How many choices are too many? What types of investments are acceptable/unacceptable? What benchmarks will be used to monitor performance? How frequently will performance be measured and by whom? Are the asset classes selected consistent with identified risk and return tolerances and time horizon? The policy may also cover how any loan program will affect investments and whether the withdrawal program is consistent with the types of funds selected. For example, if participants are expected to access funds through loans or withdrawals, do the investment funds allow for such withdrawals without penalty? Finally, the policy may deal with the regulatory issues, specifically the requirements of ERISA Section 404(c).

Prohibited Transactions

An employer’s failure to timely remit salary deferral contributions to the plan trustee is the most frequent type of prohibited transaction to occur in a 401(k) plan. Salary deferrals must be held in trust as soon as they become plan assets. Amounts paid by participants or withheld by the employer from participants’ wages as contributions to a plan will be considered plan assets as of the earliest date on which the contributions can reasonably be segregated from the general assets of the employer. In any event, that date can be no later than 15 business days after the end of the month in which the contributions are received by the employer or would have been paid to the employee in cash if not withheld from wages. [DOL Reg. § 2510.3-102(a) (effective Feb. 3, 1997)] Furthermore, if contributions can reasonably be segregated from general company assets prior to this time limit, then the employer should place the assets in trust at such earlier time. Once salary deferral contributions become plan assets, their retention by the employer is treated by the IRS as a prohibited transaction. This transaction is treated as a prohibited loan from the plan to the employer. [ Rev. Rul. 2006-38, 2006-29 I.R.B. 80] The DOL will require that the delinquent payments, plus interest, be returned to the trust. The DOL has created a safe harbor for plans with 100 or fewer participants, allowing them 7 business days to turn over plan contributions.

The following are examples of situations where prohibited transactions occur during plan design:

  • The plan hires the owner’s spouse as paid investment adviser for the plan assets.
  • The broker for the insurance contract used to fund the plan is the son of the sole director of the sponsoring employer.
  • An insurance agent sells a contract without disclosing specific information about the payment of commissions required under the applicable class exemption.
  • The plan contracts with a person to provide administrative services and agrees to pay him or her more than reasonable compensation. Care should be taken during the plan design stage to avoid selection of fiduciaries, service providers, or investment structures that might result in prohibited transactions. Plans may wish to identify significant parties in interest from the outset and use the list to screen prospective investments for conflicts.

Most banks, trust companies, and other financial institutions run disbursement checks through a master controlled disbursement account. The master account generates collected balances from uncashed checks. The collected balances are invested in short-term interest-bearing securities. The institution keeps the earnings generated on the account as a fee. (The funds are generally not able to be precisely allocated back to the plan from which the check was cut.) In 1993, the DOL advised Tennessee banking regulators that such a practice is a prohibited transaction. [DOL Adv. Op. Ltr. 93-24A] The DOL has provided guidance regarding how financial institutions can avoid a prohibited transaction from occurring through retention of this float income by providing proper disclosure. The disclosure to the plan fiduciary selecting the financial institution should include the following information:

  • The specific circumstances under which float is earned and retained.
  • For float earned on contributions pending investment direction, the specific time frames within which investment will occur following receipt of direction, as well as any exceptions.
  • For float earned on distributions, the event prompting the generation of float (e.g., check request date, check mailing date) as well as the event causing generation of float income to cease (e.g., check presentment). The disclosure should also state time frames for mailing and other administrative practices that could affect the duration of float income.
  • The rate of float or how such rate is determined.

Plan fiduciaries selecting financial services are cautioned to take the following steps to ensure that the plan is paying no more than reasonable compensation after taking into account float income:

  1. Review comparable arrangements to determine whether other providers credit float to the plan rather than the provider. If selecting a provider who retains float, verify that it makes sense given the total cost and quality of services.
  2. Review the circumstances under which float may be retained by the provider and the rate of float earnings.
  3. Ask for language in the service contract setting standards for investing cash and distributing checks to avoid unnecessary float.
  4. Periodically monitor transactions generating float (e.g., cash awaiting investment instructions, distribution checks awaiting presentment) to ensure that administrative practices are in place to minimize float income. [DOL Field Assist. Bull. 2002-3]

IRS Forms and Links

401(k) plans are required to file Form 5500 (Annual Return/Report of Employee Benefit Plan) annually with the Employee Benefits Security Administration (EBSA), formerly known as the Pension and Welfare Benefits Administration. However, as an alternative to the Form 5500, which can be burdensome, one-person 401(k) plans may file a streamlined Form 5500-EZ (Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan). Moreover, plans with assets of $250,000 or less are not required to even file the Form 5500-EZ, except in the final plan year. In order to be able to file the Form 5500-EZ, the plan for which the form is being filed must cover only the individual and his or her spouse who owns the entire business, whether or not incorporated. Furthermore, the plan may not cover a business that is a member of an affiliated service group, a controlled group of corporations, or a group of businesses under common control. As noted above, a one-person 401(k) plan that has total plan assets of $250,000 or less at the end of the plan year is not required to file a Form 5500-EZ, or any Form 5500. Plans holding assets of more than $250,000 at the end of the plan year must file Form 5500-EZ for the year in which the assets exceeded $250,000 and for each succeeding year, even if total plan assets were reduced to $250,000 or less. Thus, if an individual has a 401(k) plan with assets of $260,000 at the end of the 2011 plan year, makes a distribution which reduces the assets to $240,000 at the end of the 2012 plan year, the individual would still be required to file a Form 5500-EZ for the 2003 plan year and all following years. There is one catch. A Form 5500-EZ must be filed in the final plan year of a one-person 401(k) plan even if the total assets of the plan have always been less than $250,000. The final plan year is the year in which the distribution of all plan assets is completed.