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Reap tax bonanza for solo 401(k)

by on
in Small Business Tax,Small Business Tax Deduction Strategies

Suppose the only other employee in your sole proprietorship is your spouse who does the bookkeeping and billing. After a few lean years, business is booming and you want to sock away as much for retirement as you possibly can.

Strategy: Set up a solo 401(k) plan. Due to special tax rules, you can contribute more to this type of plan than other comparable retirement plans.

In fact, a solo 401(k) offers an un­­pre­­ce­­dented tax-saving opportunity for a married couple working together.

Here’s the whole story: For starters, you can elect to defer up to $17,500 in salary to a 401(k) plan (in both 2013 and 2014). Plus, if you’re age 50 or older, you can kick in an extra $5,500 for a maximum deferral of $23,000. The deferrals may be complemented by matching employer contributions subject to other limits.

Under the usual rules for defined contribution plans—such as SEPs and profit-sharing plans—the deductible contribution for 2013 is capped at the lesser of:

  1. 25% of salary compensation or 20% of net self-employment income or
  2. $51,000 ($56,500 if age 50 or older).

For 2014, the maximum contribution limits go up slightly to $52,000 and $57,500, respectively. Also, the maximum compensation that may be taken into account for these purposes is $255,000 for 2013 and $260,000 for 2014.

But here’s where solo 401(k)s have an edge. The limits for defined contribution plans still apply, but elective deferrals to a solo 401(k) by the business owner don’t count toward the 25% cap. What’s more, this rule extends to the business owner’s spouse.

When you combine employee contributions with employer contributions, a married couple using a solo 401(k) can hit the jackpot.

Tax benefits of going solo

Say you and your spouse are both 55 years old. You earn $120,000 a year from your incorporated business, while your spouse earns $60,000 annually.

Let’s see how the maximum contributions break down, based on 2013 figures, for you (employee No. 1) and your spouse (employee No. 2). This assumes you can allocate a large part of your compensation to retirement savings.

Employee No. 1: You can defer $23,000 to the 401(k) plan plus arrange a maximum employer contribution of $30,000 (25% of $120,000). That’s a total contribution of $53,000.

Employee No. 2: Your spouse can defer $23,000 to the plan plus your company can add another $12,500 (25% of $50,000). Thus, your spouse’s total contribution is $35,500.

In other words, the two of you can set aside $88,500 ($53,000 + $35,500). If you continue the same pattern for 10 years and earn an 8% annual return, you will have amassed a staggering $1,336,964 in a relatively short time!

If the business isn’t incorporated, the 25%-of-compensation cap on employer contributions is reduced to 20% because of the way that contributions are calculated for self-employed individuals. But that still leaves you with plenty of room to maneuver. For instance, if your net self-employment income is $125,000, you can still stash away up to $48,000 ($23,000 + $25,000) in the account.

Finally, a solo 401(k) plan may offer other advantages, such as the ability to make hardship withdrawals or take out a loan. In addition, you might roll over funds tax-free from another qualified plan to your solo 401(k) if you previously worked somewhere else.

Tip: Contributions are discretionary, so you can cut back on the match, or skip it entirely, in a down year for the business.

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