If you’re looking for a way to max out your contributions to a deductible retirement account, the solo 401(k) plan is an option to strongly consider.

With a solo 401(k), you can contribute your maximum annual contributions like you would to any other 401(k) plan; $17,000 of your 2012 compensation or self-employment income ($22,500 if you’ll be 50 or older at year-end.)

But here’s the real ‘sweet spot’ for this option. You can contribute and deduct an additional amount of up to 25% of your compensation income, or 20% of your self-employment income.

Below is an example of how this works. And by the way, to be eligible for the solo 401(k), the assumption is you’re the only employee of your business, corporation, LLC or PLLC or it’s you and your spouse or you and your office manager/assistant. You can of course hire independent contractors and still qualify.

Boost Your Savings

You own Fun Inc. (FI) and in 2012 FI, your corporation, plans to pay you $100,000 in annual salary. You’re 53, so you’re eligible for the catch-up contribution as well, so for this year, your 401(k) salary deductions to your solo plan will total $22,500.

And here’s where the solo plan boosts your savings amount even more. In addition to your annual salary deferrals totaling $22,500, your company can also make profit sharing and matching contributions on your behalf as well for up to 25% of your salary, offering you an opportunity to invest up to $47,500 total for 2012 in this example:

{$22,500-salary deferral+(25% profit sharing & company match of $100,000)}= $47,500

Big Tax Savings Potential

Take it a step further and say you’re in the combined Federal and State tax bracket of 40% for 2012. Your potential tax savings for 2012 would be $19,000. And yes, you read that correctly. In this hypothetical example, by combining your total salary deferral contributions with your company’s 401(k) match along with a profit sharing contribution, you are potentially paying $19,000 less to the IRS and state tax authorities:

$47,500(total salary deferral and company contribution) x 40% (tax rate) = $19,000

For 2012, the combined company and salary deferral solo 401(K) maximum contribution amount is $50,000 or $55,500 for 50 or over.

3 Major Benefits of a Solo 401(k) Plan

When I put my strategic tax planning hat on, I’m constantly on the lookout for optimal tax strategies that are nimble and flexible as much as they are savvy.

• One of the major benefits of the solo 401(k) plan is the flexibility it offers in terms of annual contributions. While some plans, especially defined benefit plans require mandatory minimum contributions each year regardless of cash flow or projected profit, the solo 401(k) plan  allows you flexibility in terms of your annual contributions. And from a tax planning perspective, being able to align your retirement planning strategy with your tax planning strategy, well that’s a winning combo you’ll find hard to beat.

• Major benefit number two – During the boom years when cash is flowing like a mighty river and profits are strong, the solo 401(k) plan is your ticket to major tax savings. You’ll reap those savings by maxing out your contribution to your solo plan which in return will significantly lower your tax bill for your current tax year. This strategy is simple and straight forward: Max out your solo 410(k) contributions in the cash flow positive years, save big money on taxes as a result, then reinvest those savings in your practice or business.

Creating significant tax savings in the cash flow positive years, while providing you the option to contribute less (or zero) in the lean years, when conserving cash is your highest priority.

• Major benefit number three – Many small business owners usually start off with a Simple IRA plan for their business, even when the practice or business is a solo venture. There are many reasons for this, the main one being the simplicity of establishing this type of retirement plan. Yet what very often happens is that your income grows significantly over the years and you end up outgrowing your Simple IRA plan, never exploring alternatives.

When you compare a Simple IRA retirement plan where the maximum contribution in 2012 for age 50 or over equals $14,000 and contrast that with a solo 401(k) plan, maximum contribution for age 50 or over equals $55,000, it’s no contest.

This may sound odd, especially considering I majored in tax accounting during college; I feel good overall about paying my fair share of taxes. And the more I make, the more I ought to pay.  That doesn’t mean I will not use the knowledge I gained to play the tax game in a smart and sensible way as illustrated in the above example.

But tax policy at its core is about the type of society we all want to live in. It’s about fairness and it’s about paying it forward for the next generation.  Watch Elizabeth Warren, hopefully our next Senator from the great state of Massachusetts say it best:   

As a registered investment advisor, we can establish and manage your solo-401(k) plan through our institutional custodian, Charles Schwab.

Let us help you become a smart and savvy small business owner today.

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