Win Big With a Solo 401(k)
A client's business finally started to make money after many lean years. He didn’t want to spend it all on taxes, and he needed to fund his retirement plan heavily to catch up for the years he couldn’t contribute.
Enter the 401(k) plan. Due to special tax rules, a solo 401(k) offers a much bigger tax reduction benefit than other choices. Each employee can defer up to $17,500 in salary to a 401(k) plan for
2014. Plus, employees older than 50 years old can contribute an extra $5,500 catch-up contribution for a total annual deferral of $23,000.
The employer may make a matching contribution up to the lesser of (1) 25 percent of salary compensation or 20 percent of net self-employment income, or (2) $52,000 ($57,000 if age 50 or older). The maximum wages that can be taken into account for these plans is $260,000 for 2014.
But here is where a 401(k) has an advantage. The 25 percent limit (20 percent of net self-employment income) does not apply to the elective salary deferrals for both the business owner and their spouse.
When you combine employee contributions with employer contributions, a married couple using a 401(k) can hit the tax-saving jackpot.
Let's say you and your spouse are both older than 50 years old. Let’s assume you have a salary of $120,000 a year from your incorporated business and your spouse is paid $60,000 a year. Let’s calculate the maximum you and your spouse can contribute.
You can defer $23,000 to the 401(k) plan plus an employer contribution of $30,000 (25 percent of $120,000) for a total of $53,000.
Your spouse can also defer $23,000 to the 401(k) plan, plus an employer contribution of $15,000 (25 percent of $60,000) for a total of $38,000.
The two of you can contribute and deduct a total of $91,000 per year. Assuming a 28 percent tax bracket, you will save $25,480 per year. Over 10 years you will save $254,800 in taxes and accumulate retirement savings totaling $1,318,277 (assuming an 8 percent return).
A solo 401(k) plan may also offer other advantages, such as the ability to make hardship withdrawals and borrow against it. In addition, you might roll over funds tax free from another qualified plan if you previously worked elsewhere.
The retirement contributions are discretionary, so you can cut back on the match or skip it entirely during a rough patch when your business may be struggling.