Welcome to the Tax Blog

02 January 2019

I don’t regret one minute of my Navy career, but if I had realized how much fun it is to be an entrepreneur and business owner, I would have done it a long time ago. Building this tax business (and now building Redeployment Wealth Strategies with Sean) has been, and continues to be, both fun and gratifying. One of the most enjoyable aspects of these new careers is the opportunity to meet other entrepreneurs/small business owners. We are a strange and interesting breed, and I like spending time with (and helping whenever possible) other members of my tribe.

A question I frequently receive from clients with their own start-up business is how to protect profits from taxation. This question typically comes in the second or third year of business operations. The first year is rarely profitable for a new business as the costs involved with starting the business usually take up all the available revenue. After two or three years, however, many new businesses start to show a profit and people start to wonder if they are being as efficient as possible with their taxes. (Managing taxes being an essential task of the small business owner.)

My favorite response for sole-proprietors is to establish a Solo 401K. Not only does it allow the entrepreneur to avoid a good chunk of state and federal income taxes, but it also serves another purpose - retirement planning. Starting a business tends to consume all of one’s mental resources for the first few years. That's how it was for me. It seems like all my waking time was spent thinking about the business. Who has time for retirement planning? Most of us either forget about it altogether, decide to think about it ‘later’, or just figure we like what we are doing so much we aren’t ever going to retire anyway! (A haphazard planning strategy that ruffles my financial planner's feathers!)

As the name implies, a Solo 401K is designed for one person. As with nearly all government regulations, however, there are exceptions to the rule. If both you and your spouse work for the business, you can have a Solo 401K. If you have formed a partnership where only the partners are working in the business, you may also have a Solo 401K. If you have common-law employees in your business, you cannot use a Solo 401K. (You would need to establish a different retirement plan in which your employees can also participate.)

Solo 401Ks are also surprisingly easy to establish. All the large online brokerages (Vanguard, Fidelity, Schwab, TD Ameritrade, etc.) have fast and simple online applications. They are also easy to maintain administratively compared to 'regular' 401K plans. While a regular 401K plan requires additional tax returns and compliance documents, the Solo 401K only takes filling in a few extra lines of your current tax return each year.

Solo 401K Contributions:

What makes the Solo 401K so powerful as a tax planning tool is the ability to make tax-free contributions to it. There are two categories of contributions to a Solo 401K if you are under 50 and three categories of contributions if you are 50 & over. Let’s take a look at each:

Elective Deferral: This is essentially the same contribution as the one you may have made as an employee. (If you were in the military and participated in the TSP retirement plan, your contributions were officially known as your elective deferrals.) In 2019 you can contribute up to $19,000 into your Solo 401K via elective deferral. The caveat is that you have to earn at least that much from the business in order to make the contribution. In other words, your elective deferrals are limited to the smaller of $19,000 or 100% of your profit/compensation from the business.  

Employer Contribution: If you were an employee you used to call this ‘matching money’. That’s the part you can put into the 401K as an employer. In 2019 that amount is limited to $56,000. Before you get delirious about that number, there are some important limitations to discuss. The first is that for self-employed people you are essentially limited to 20% of your total compensation net of the deduction you take for paying self-employment taxes. (There is a fancy formula and IRS worksheets to determine this limit, but 20% is pretty darn close. See IRS pub 560 is you want to see the formula and worksheets.) You also have to reduce that $56,000 limit by the amount of your elective deferrals. So, the combination of elective deferral and employer contribution into your Solo 401K cannot exceed $56,000. Note: the employer contribution for W-2 employees is 25% of compensation. If you have elected S-Corp tax treatment for your business, you are paid on a W-2, and only your W-2 income counts toward the Solo 401K limit. (The amount reported on your K-1 does not count as compensation for the purposes of calculating your Solo 401K contribution limits.)

Catch-Up Contribution: If you are 50 years old or older, you can also contribute an extra $6,000 to your Solo 401K. When you add that to your combined limit of $56,000 from your elective deferral and employer contribution, you have the potential to shelter up to $62,000 from state and federal taxes in 2019.

Here’s a table showing the types of Solo 401K contributions and the 2019 limit for each:

* Cannot exceed $56,000 when combined with Elective Deferral.

** Compensation does not include S-Corp shareholder payouts from K-1 (W-2 income only from S-Corp).

Examples:

Debbie, age 40, is the sole proprietor of a schedule C business.  She does not have any employees, and in 2019 her income net of the deduction for self-employment taxes is $50,000. Her 2019 Solo 401K contribution limit is $29,000.

She can contribute up to $19,000 as her elective deferral.

She can contribute $10,000 (20% of $50,000) as the employer contribution.

She is under 50 and cannot make the catch-up contribution.

Jerry, age 55, is a sole proprietor who has elected S-Corp treatment. He is the only employee of his S-Corp. In 2019 he pays himself $100,000 on his W-2 and takes another $200,000 as a shareholder distribution on his K-1. His 2019 Solo 401K contribution limit is $50,000.

He can contribute $19,000 as his elective deferral.

He can contribute $25,000 (25% of $100,000) as his employer contribution. (The money from the K-1 does not count toward the employer contribution limit.)

He can contribute an additional $6,000 for the catch-up contribution.

Monique, age 28, is an RN by day, but has a side business she works nights and weekends. She files on a schedule C and in 2019 her side business makes $300,000.  She contributes $8,000 to the 401K at her nursing job, and receives a 50% match from her nursing employer for $4,000.

She can contribute up to $48,000 to her Solo 401K

She can contribute $11,000 via elective deferral ($19,000 - $8,000; the elective deferral limit is cumulative no matter how many jobs one has.)

She can contribute up to $37,000 ($56,000 - $19,000) for the employer contribution. (The employer contribution limit is separate for unrelated employers, so the $4,000 match she received from her nursing job does not reduce the amount she can contribute to her Solo 401K.)

That last example was tricky, as I snuck in a couple of concepts without much explanation. While Solo 401ks are much simpler than regular 401Ks, there are still quite a few details. Strategies can also be tricky, as you may want to determine the path giving you the most advantageous tax situation if you need to pay self-employment taxes. I find modeling these scenarios is the best way to ensure you are getting the best tax result consistent with your retirement planning strategy. If you’d like to discuss strategies or run through a few scenarios with Solo 401K planning, give me a call.