Solo 401(K) – Tax Break for Small Business Owners

This time of year many of my clients are trying to figure out how the can reduce their tax liability for next year.  So while reading the news this week, I’m sure you can understand why this headline caught my attention:   A Solo 401K Plan Can Cut Your 2011 Tax Bill by $9,800.  But Need to Act Soon.

Since this kind of tax savings would interest the majority of my clients, I thought today’s lesson should be all about the Solo 401K tax break. 

What is a Solo 401K?

Before we break out into the nuts and bolts of the solo 401K, let me give you three good reasons why you might want to learn more about it: significant tax savings, higher contribution limits, and tax-free loan option.

In the past, 401k plans were typically offered by larger corporations. Employees could make pre-tax contributions by payroll deduction and the company would often times match a percentage of those contributions.  Investments grew tax-free until withdrawn at retirement.

A Solo 401K is very similar only it has been designed for the small business owner.  It’s available to sole proprietors, S corporations, LLC’s, and partnerships.  There are really only two qualifications. 

First, you must be self-employed or have some moonlighting income from self-employment.  If you are incorporated, your self-employment income comes from the wages you pay yourself.  Second, you must be the sole owner.  That’s a business with just you and possibly your spouse, but no employees.

Why a Solo 401K versus a traditional SEP, SIMPLE or Keogh plan?  One of the advantages with a Solo 401K is that it enables you to put more away for retirement than these other plans allow.  That’s because you are able to make two types of tax-deductible contributions.

First you make the usual employer contribution as owner of the business. Then you can make an additional salary deferral as an employee. As a result, you could potentially shelter up to $49,000 of your 2011 self-employment earnings from tax. If you’re eligible for the over-50 catch-up, that rises to $54,500.

Example: Luke is a software architect (age 30) and is sole owner of his S corporation Fruit Luke, Inc.  His officer wages for 2011 were $50,000.  Luke can contribute $16,500 to his solo 401k.  His taxable W2 earnings would be reduced from $50,000 to $33,500.  His S corporation can make a profit sharing contribution of $12,500 (25% of $50,000) and deduct it as a business expense.  Total Solo 401K contribution for 2011 is $29,000.  Assuming Luke has a combined Federal and State tax rate of 30%, his tax savings would be approximately $8,700.

But what if I don’t have that type of cash to contribute?

You may still want to consider a solo 401K.  That’s because it has a feature not available in other retirement savings accounts – the option of a tax free loan.

You can make a loan, tax-free, using your solo 401K account as collateral.  It allows loans of up to 50% of your balance, for any purpose.  This allows to you take money out of the retirement account without paying an early withdrawal fee.  Normally, the loan has to be paid in five years, but that could be longer if the money is used to purchase a home.  Just be careful.  If you don't make a repayment on time, the loan balance becomes a taxable distribution, with a 10% penalty if you are under 59 and a half when the plan reports the distribution to the IRS.  So be sure you can repay it.

Another strategy is if you have an existing IRA or 401K from a previous employer, you can roll the funds into your new solo 401K and once the transfer is complete you can borrow up to $50,000, or half the balance of your new 401K, whichever is less.  You can always borrow at least $10,000.  If the ability to borrow is important to you, make sure the custodian you choose allows loans, since not all do.

This tax free loan option is not available in SEP IRA’s, Simple IRA’s or regular IRA’s. Were you to simply withdraw the funds from the IRA, you'd owe ordinary income taxes and possibly a 10% penalty too, if you're not yet age 59 and a half.

So is the Solo 401K right for you?

As I mentioned earlier, a Solo 401k is not a great idea for a business that has employees. If you make maximum contributions to your Solo account you will also have to match the same for all your employees. This is one aspect to consider well before you set up a Solo 401k for your business, especially if you propose to add employees at a later stage.

Another downside to the solo 401K is it requires more paperwork than a SEP or Simple IRA.  The simplest approach is to contribute to a plain old IRA rather than the Solo 401K.  But if the loan feature and higher contribution limits are important to you, this makes it a compelling option.

Deadlines to consider

If you want to go the Solo 401K route, you need to have the plan set up by year-end, maybe earlier depending on the provider. 

The employee salary contribution must be made by December 31st. 

However, you have until the filing deadline of the return to make the employer contribution.  If you are incorporated, that date is March 15th. 

If you are interested in learning more about Solo 401K plans and whether they are a good option for you, call me to set up an appointment.  My contact information is on my website.