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