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Solo 401(k) A Smart Tax Saving Strategy for the Solo Entrepreneur

Mark Zaifman   |    Mon, Oct 18, 2010 @ 08:41 PM

solo 401kFor most small business owners, discussing the pros and cons of a pension plan vs. a 401(k) vs. a SEP IRA is about as exciting as watching paint dry. I get it. Yet, I’ve noticed over the years just how much time entrepreneurs invest in growing their business and how little time and money they spend on designing smart and sensible tax savings strategies that could save them big money at the end of the year.

Welcome to the Solo 401(k) plan.  This came about in 2002 after Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001. This option allows the solo business owner an opportunity to not only defer taxes but to save and invest more money than they could in a SEP IRA plan, all things being equal.

My Client Saved Over $8k in Federal and State Income Taxes

Here’s how it worked. I started working with Client X almost 2 years ago. She lives in the Bay Area and owns a very successful business. When I first reviewed her financial data, I noticed she was using a SEP IRA to fund her retirement. As part of my review during the financial planning process, I compared her SEP maximum contributions to that of a Solo-401(k) and guess what I discovered? By using a Solo-401(K) for her retirement as opposed to her current SEP-IRA, she was able to save approximately $8,000 on Federal and State income taxes.

Although she had a tax preparer that, in my opinion, should have recommended this retirement strategy back in 2002, in all fairness to the tax preparing profession, their main objective is to prepare and submit your tax return to the proper authorities with zero errors. Tax planning and tax strategies can be, but are often not included in tax preparation services.

Here’s How it Worked

Instead of providing actual client numbers, let’s assume Client X had net-income from her business of $115k for 2009. Let’s also assume Client X is in her early 60’s and she operates her business as a sole proprietorship. With her SEP-IRA, the maximum tax deferred contribution she can make is $23,000. One major negative of the SEP-IRA (for those age 50+) is that there isn't an additional $5,500 catch-up contribution provision like there is with the Solo 401k.

Who Would Benefit From Using a Solo 401k?

Here's how the calculation works. In 2009 and 2010, participants in a Solo 401k can contribute up to 100% of the first $16,500 ($22,000 if age 50+) of W-2 compensation or net self employment income for a sole proprietorship. In addition, a profit sharing contribution can be made up to 25% of W-2 wages or 20% of net self employment income. The contribution limit calculation in a Solo 401k is important because it allows you to potentially save more than a SEP IRA at the same income level.

Following my recommendations, Client X used the Solo 401(k) and contributed a total of $45,000 into her retirement plan for 2009 as opposed to the maximum $23,000 available through a SEP-IRA. Based on her income tax bracket, she saved $8,000 in Federal and State Income taxes.

What about you? Are you taking advantage of the latest money saving tax strategies? If you are a small business owner, you may want to reconsider your options.

Solo 401k

Photo credit http://www.flickr.com/photos/solo_with_others/