Skip to content

Tax Tips: Save More with a 401(k)

I have several clients who are self-employed and currently experiencing a great deal of financial success in their business. By creating a personal (or “Solo”) 401k plan for them, we have enabled them to defer income tax on as much as $56,000 ($62,000 if they are age 50 or older) per year, or twice that amount if both spouses are employed by the business.

Here’s an example: A sole proprietor under the age of 50, with a net income of $50,000 from the business this year, could contribute approximately $28,000 of these earnings to their Solo 401k plan.  If they are currently in the 22% tax bracket, this would effectively defer over $6,000 of tax until they eventually withdraw the funds from the 401k in retirement.

Here are some basic rules for creating and contributing to a Solo 401k. 

  1. There can only be one participant in the plan, or two spouses if both work for the business.
  2. The business cannot have any other employees.
  3. Acceptable business forms include sole-proprietorship, LLCs, partnerships, s-corporations, and c-corporations, as long as there is only one owner, or the two owners are married to each other.
  4. The 401k must be established prior to December 31st (or the legal entity fiscal year-end.)
  5. The employee contribution to the account must be made by December 31st each year, but the employer contribution can be made as late as the filing of the Federal income tax return.
  6. Once the plan value exceeds $250,000 the IRS requires form 5500-SF to be filed annually.
  7. Similar to an IRA or traditional 401k plan, distributions from the plan prior to age 59 ½ will generally result in a 10% early withdrawal penalty.

As noted above, there are technically two types of contributions that can be made to a Solo 401k plan each year, and this is why these plans allow for such a high overall contribution. For employees who work for a larger company that offers a 401k plan, the employee is allowed to defer part of their wages each year on a pre-tax basis (this is called an elective deferral.) Their employer can then choose to contribute to the account as well, such as with a matching contribution (this is called the employer nonelective contribution.)  As a small business owner, you are technically both the employee and the employer, so the IRS allows you to make both the elective deferral as an employee and the employer nonelective contribution from business profits.

The legal entity type that you have chosen for your business will impact the calculation on how much you can contribute to the Solo 401k each year. Since the calculation for each entity type is beyond the scope of this article, you should work closely with your financial advisor and/or CPA to determine the annual contribution limits and the deadlines for making contributions each year.

K. Paul Hansen, CFP® CPA

Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. HFG Trust has no duty or obligation to update the information contained herein. Further, HFG Trust makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is potential profit there is the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicit and securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. HFG Trust believes that the sources from which such information has be obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, included the information contained herein, may not be coped, reproduced, republished, or posted in any form without the prior written consent of HFG Trust.