Have you been like so many other taxpayers and procrastinated about setting up a retirement plan for your small business? Here’s why you shouldn’t wait any longer. You are paying income taxes that could easily be avoided. So consider establishing a plan to give  yourself an opportunity for future tax savings while providing for financial security in retirement.

A relatively new retirement plan alternative for a profitable one-person businesses is the solo 401(k). The main solo 401(k) advantage is the potential for larger annual deductible contributions you can make on your behalf.

Rules for Solo 401(k) Account Contributions

Annual deductible contributions to a solo 401(k) for a business owner is typically comprised of two different parts.

First Part: Elective Deferral Contributions

For 2020, you can contribute as much as $19,500 to your solo 401(k) of:

  • Your salary from your own C or S corporation, or
  • Your net self-employment income if you operate as a sole proprietor or as a single-member LLC that’s treated as a sole proprietorship for tax purposes.

The contribution limit increases to $26,000 if you are 50 or older as of December 31, 2020. The $26,000 figure includes an extra $6,500 catch-up contribution allowed for older 401(k) plan participants.

This first part, called an “elective deferral contribution,” is made by you as the covered employee or business owner.

  • With a corporate solo 401(k), your elective deferral contribution is funded with salary reduction amounts withheld from your company paychecks and contributed to your account.
  • With a solo 401(k) set up for a sole proprietorship or a single-member LLC, you simply pay the elective deferral contribution amount into your account.

Second Part: Employer Contributions

In addition to your elective deferral contribution, the rules for solo 401(k) plans allow another contribution of up to 25 percent of your salary or 20 percent of your net self-employment income to be made.

This additional amount is called an “employer contribution.” For purposes of calculating the employer contribution, your compensation or net self-employment income is not reduced by your elective deferral contribution.

  • With a corporate plan, your corporation makes the employer contribution on your behalf.
  • With a plan established by a sole proprietorship or a single-member LLC, you are treated as your own employer and thus, make the employer contribution on your own behalf.

Combined Contribution Limits

For 2020, the combined elective deferral and employer contributions cannot exceed:

  • $57,000 (or $63,500 if you will be age 50 or older as of December 31, 2020), or
  • 100 percent of your corporate salary or net self-employment income.

For purposes of the second limitation, net self-employment income equals the net profit shown on Schedule C, E, or F for the business in question minus the deduction for 50 percent of self-employment tax attributable to that business.

Example 1: Corporate Solo 401(k) Plan

Marianna, who is 45 years old, is the only employee of her corporation and receives a salary of  $80,000 in 2020.

The maximum deductible contribution to a solo 401(k) plan set up for Marianna’s is $39,500. The amount is calculated as follows:

  1. Marianna’s $19,500 elective deferral contribution, which reduces her taxable salary to $60,500, plus
  2. A $20,000 employer contribution made by the corporation (25 percent x $80,000 salary), which has no effect on her taxable salary.

The $39,500 amount is well above the $20,000 contribution maximum that would apply with a traditional corporate defined contribution plan (25 percent x $80,000). The $19,500 difference is a result of the solo 401(k) elective deferral contribution privilege.

Variation:  Let’s assume Marianna will be age 50 or older as of December 31, 2020.

Now, the maximum contribution to Marianna’s solo 401(k) account is $46,000, which consists of

  1. A $26,000 elective deferral contribution (including the $6,500 extra catch-up contribution), plus
  2. A $20,000 employer contribution (25 percent x $80,000).

Again, that’s much more than the $20,000 contribution maximum that would apply with a traditional corporate plan (25 percent x $80,000). Here as well, the difference is due to the solo 401(k) elective deferral contribution privilege.

Example 2: Self-Employed Solo 401(k) Plan

Lance, age 40, operates his real estate appraisal business as a sole proprietor (or as a single-member LLC treated as a sole proprietor for tax purposes).

In 2020, Lance has net self-employment income of $80,000 (after subtracting 50 percent of his self-employment taxes).

The maximum deductible contribution to a solo 401(k) plan set up for Lance’s benefit is $35,500. This is comprised of:

  1. A $19,500 elective deferral contribution, plus
  2. A $16,000 employer contribution (20 percent x $80,000 of self-employment income).

The $35,500 amount is well above the $16,000 contribution maximum that would apply with a traditional self-employed plan set up for Lance’s  benefit (20 percent x $80,000). The $19,500 difference is due to the solo 401(k) elective deferral contribution.

Variation: Assume Lance will be age 55 as of December 31, 2020.

In this variation, the maximum contribution to Lance’s solo 401(k) account is $42,000, which consists of:

  1. A $26,000 elective deferral contribution (including the $6,500 extra “catch-up” contribution), plus
  2. A $16,000 employer contribution (20 percent x $80,000).

That’s much more than the $16,000 contribution maximum that would apply with a traditional self-employed plan (20 percent x $80,000). The $26,000 difference is due to the solo 401(k) elective deferral contribution.

As you can see, in the right circumstances, the solo 401(k) can make for a great retirement plan. If you would like to discuss the rules for solo 401(k) plans, please contact us at 561-826-9303.