DO YOU RUN YOUR business as a one-person show? Have we got a deal for you: the so-called solo 401(k) plan is a little known but very efficient way for self-employed folks to save for retirement.
This means you can quickly build up a substantial tax-deferred retirement account balance while cutting your annual income tax bills.
As you probably know, traditional small-business retirement plans such as Simplified Employee Pension (SEP) allow annual deductible contributions equal to 25% percent of your compensation (if you’ve set up your business as a corporation) or 20% of your self-employment income (if you’re a sole proprietor), with a maximum dollar cap of $53,000 for 2015.So, say your solely owned corporation pays you an $80,000 salary. The maximum deductible contribution to a company profit-sharing plan set up for your sole benefit would be $20,000 (25% of $80,000). Now, say you earn $80,000 of self-employment income from your sole proprietorship. In this case, the maximum deductible contribution to your self-employed Keogh or SEP account would be $16,000 (20% of $80,000).
Not bad, but you might wish you could funnel more (maybe a lot more) into your tax-favored retirement program. After all, assuming you have the cash to do so, bigger deductible contributions lower your tax bills and generate more tax-deferred earnings for your retirement stash as well. It’s a tax-saving double play.
The Solo 401(k) Alternative
Enter the solo 401(k) plan. For those who are looking for an even larger annual contribution to a deductible retirement account, it’s a major improvement. The reason: With a solo 401(k), annual contributions consist of two parts. And in this case, two is definitely better than one.
First, you can contribute up to 100% of the first $18,000 to $24,000 of your 2015 compensation or self-employment income. And there’s more: You can contribute and deduct an additional amount of up to 25% of your compensation income (if you’re a C corporation), or 20% of your self-employment Schedule C reported income. This second part of your annual contribution is like what you can do with a traditional small-business retirement plan like a SEP (with a cap of $53,000).
To see how the two parts stack up, let’s go back to our examples.
Your corporation pays you $80,000 this year. The maximum deductible contribution to your solo 401(k) account could be as much as a whopping $44,000. That’s a lot more than the $20,000 you could contribute to a traditional plan (25% of $80,000).
Now say you earn $80,000 from your sole proprietorship. The maximum solo 401(k) contribution would be an impressive $40,000
Of course, if you make more than the illustrated $80,000 from your solo business activity, you can contribute even larger amounts to your solo 401(k). At an income level of $265,000 your possible contribution would be $53,000 plus $18,000 (or $24,000 if over age 50) a total tax deduction of $71,000 to $77,000.
Bottom line: For those who hate to leave any tax break on the table (and I hope there are lots of you), the solo 401(k) is one sweet deal. And never fear: You won’t be forced to contribute more than you can comfortably afford in years when cash is tight. You can always pay in less than the tax-law maximum or even nothing at all. In other words, the solo 401(k) lets you rack up major tax savings in the good years, while leaving you the option to contribute less (or zero) in the lean years, when conserving cash is your highest priority.
Is there a Catch?
If you have employees, the tax law may require you to contribute to their accounts as well as your own. But this is an issue with any type of tax-deferred retirement program. Also, by definition then you are not talking about a “Solo” 401k. However if your spouse is your only employee, or co-proprietor the solo 401K still makes sense. So, if you have employees, I can help you calculate the implications before you make a decision.
A one-participant 401(k) plan is generally required to file an annual report on Form 5500-SF or form 5500EZ if it has $250,000 or more in assets at the end of the year. A one-participant plan with fewer assets may be exempt from the annual filing requirement.
Fortunately, with a solo 401(k), this is only a minor concern, because you’re the only participant. We can help you handle this in about a half an hour.
Don’t Miss the Year-End Deadline!
You must establish your plan by Dec. 31 of the year for which you want to claim a tax deduction. However, you have until you file your return to actually fund the plan.