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Cut your Tax Bill by $10,000 with Solo 401k!

Apr 5, 2015

Posted by

Dmitriy Fomichenko

Dmitriy is a founder and president of Sense Financial Services LLC, and started his career in financial planning and real estate investing in 2000.  For over seven years, he worked for t Read more

If you are self-employed or have a small business, the idea of a 401k may make you jump to two conclusions:  “My company is too small” and “I can’t afford it.”  Well, you’re not … and you can!

A Solo 401k is inexpensive to set up and easy to maintain – and it delivers substantial tax and saving advantages.  Use a Solo 401k Plan if you’re self-employed or run an owner-only business.  You could add multiple owners and spouse to a Solo 401k Plan, but if you add full time employees to your business, you’ll need to convert to a more traditional plan.

Solo Benefits, Duo Roles

One benefit of a Solo 401k is that you assume the role of both employer and employee, which allows you to contribute up to $50,000 ($55,500 if you age 50 or older) of your annual income, tax-deferred, for 2012.  Contributing the highest amount may lead you into a more advantageous tax bracket that accelerates the time to retirement – another benefit!

High Solo 401k Contribution Limit, tax advantages and penalty-free loans make the nominal price for a Solo 401k a wise financial move if you want to defer more of your income than the traditional IRA limit of $5,000 a year.

Up to now, many entrepreneurs have used traditional IRAs to save for retirement – a strategy which offers lower contribution limits and includes the risk of penalties incurred on owners who accessed funds before reaching retirement age.  The Solo 401k presents more flexibility than about any retirement account, including IRAs.

Let’s compare 401k with Traditional IRA:  The traditional IRA has a $5,000 limit per individual; The 401(k) limit is $50,000. The catch-up contribution (Age 50+) is just $1,000 with a traditional IRA. The 401(k) allows $5,500. The 401(k) does not have an income limit. With the traditional IRA, the amount you can contribute starts phasing out at $110,000 annual income and no contributions are allowed if you are making $125,000 or more. And the 401(k) also allows you to borrow from it without taxes or penalties.

How to Save $10,000 in Taxes in 2012

Let’s look at the example how a sole-proprietor younger than 50 years old, can max out his retirement savings and lower taxes for 2012:

Assume annual earnings of $165,000.  With an employee contribution of $17,000, and a profit-sharing contribution of $33,000 (up to 20% of net self employment), the total savings is $50,000 and taxable income is reduced to $115,000.

While the owner earned $165,000 in 2012, only $115,000 is IRS taxable.  Assuming an adjusted gross income tax rate of 20 percent, that’s $10,000 he can keep for himself (versus paying Uncle Sam).  What’s more, the savings are likely to be even greater because his tax bracket will probably drop.  For example, the married filed joint return 2012 tax rate increases from 25% to 28% for income over $142,700.

Solo 401k Contribution Deadline:

While business owners will have until their tax deadline to contribute to their 401k accounts, IRS requires their plans to be set up by December 31 to qualify.  Many providers have deadlines well before the 31st, so setting up sooner rather than later is the smart option.

Majority of businesses likely have until April 15, 2013 to make the contributions for 2012.  However if company was established as a corporation, the deadline moves back to March 15.  But don’t despair: by setting up a plan by the end of the year, you will have time to determine the optimal amount to best manage your tax and retirement savings.

One final tip:  If Solo 401k Loan and Roth Solo 401k options are important to your investment strategy, be sure to use a provider who offers a full-featured, totally self-directed Solo 401k plans such as Sense Financial.  Some providers offer an individual 401 k plan with administrative services and few investment options from the array of investments they support.  Such plans are not truly self-directed, limit your investment options, not allowing you to invest in non-traditional investments such as real estate and probably will lack Roth-subaccount and loan feature of the plan.