Solo 401(K) Saves Tax for Small Family Business
People are scrambling to finish their 2013 tax year return and wondering how they can save tax for the 2014 tax year. The Solo 401(k) is a strategy that few utilize. It is designed for small business owners who have only family employees. The limit is two participants, which typically is the business owner and the spouse. The Solo 401(k) is not a new type of 401(k) plan and has the same rules and requirements as any other 401(k) plan. More details can be found on the IRS website (1) and search for "Retirement-Plans-One_Participant-401k-Plans".
How much can one contribute? The business owner wears two hats in a 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can elect to defer up to 100 percent of compensation (also known as earned income for the self-employed) up to $17,500 for both 2013 and 2014 tax years. If he is age 50 or over, there can be an extra $5,500 (called the "catch-up" contribution) to make the total $23,000 per year.
The second part is the employer contribution of up to either 25 percent of the compensation defined by the plan, typically wages, or a different calculation for the self-employed individual. One defines one's compensation as "earned income", which is net earnings from self-employment after deducting half of one's self-employment tax (calculated on Schedule SE). Then 20 percent of this number is what the employer contribution is. The total of both the employee salary deferral as well as the employer contribution cannot exceed $51,000 for 2013 and $52,000 for 2014. If the individual is age 50 or over, there can be an extra $5,500 "catch-up" contribution, making the total maximum contribution to the Solo 401(k) plan $56,500 for 2013 and $57,500 for 2014.
Example of a Schedule C, unincorporated small business, where the owner is at least age 50 and the net profit in 2014 is $200,000:
One calculates the Section 1402(a)(12) Deduction, which reduces the figure to $184,700. Next one uses Schedule SE to calculate FICA and Medicare Tax, which totals $19,864.30. Half of this is $9,932,15, and is subtracted from $200,000. The result is $190,067.85 of Self-Employment Income. The maximum Employee Salary Deferral contribution is $17,500 plus $5,500 or $23,000. If one takes 20 percent of $190,067.85, the maximum employer profit sharing contribution is $38,013.57. The total of the two contributions is $61,013.57. However, one cannot exceed the total limit of $57,500. Note: a step-by-step worksheet for this calculation can be found in IRS Publication 560. In contrast, the contribution limit for a SIMPLE IRA plan would be $20,035.96 or $38,013.57 for a SEP IRA plan. One can contribute substantially more to a Solo 401(k) instead of these other two employer IRA plans, and certainly much more than the $6,500 limit for a traditional individual IRA plan.
Deadlines: One must establish your Solo 401(k) plan by December 31, 2014, if you want to make a contribution for tax year 2014 and reduce taxable income. The contributions must be funded by your tax-filing deadline. If one files for the 6-month extension before the April 15, 2015 deadline to file one's 2014 tax return, one would have until October, 15, 2015, to make the cash contribution.
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