If you're a small-business owner without employees, you're probably familiar with both the exhilaration and travails of going it alone. With a gradually improving economy, more small-business owners may be in a position to defer income this year and next. If you're wondering how to lower your self-employment tax bill, consider a one-participant 401(k) plan, better known as a "solo 401(k)," a flexible retirement vehicle with a plethora of advantages to solo entrepreneurs. If your spouse works in your business and is part of the plan, the advantages increase.
How it works
The solo 401(k) is similar to a traditional 401(k) plan, but it differs in several important aspects. In the solo 401(k) plan, the business owner acts as both employee and employer, thus creating an opportunity to make an elective deferral as an employee and a nonelective contribution, or match, as an employer. Does this sound like double the fun?
If you run an incorporated or partnership business (i.e., an S-corp or LLC), you can defer 100% of your compensation (typically your W-2 wages) into the plan, up to a maximum of $17,500 for 2013, with an additional $5,500 of catch-up deferral available if you are 50 or older. You can then match this amount on the employer side, with a contribution of up to 25% of compensation.
If you are an unincorporated sole proprietor, the formula is similar, but "compensation" is defined as earned income. Earned income in this case equals your net self-employment earnings after removing one-half of your self employment tax and your elective deferrals.
Suppose an S-corp owner under the age of 50 received $75,000 in W-2 wages in 2013. If his or her solo 401(k) plan allowed the maximum 25% employer contribution, the total contribution to the solo 401(k) account would be as follows:
-- $17,500 employee maximum deferral
-- $18,750 employer contribution match
Total contribution: $36,250
Between your deferrals as an employee and your matching contributions as an employer, total contributions are capped at $51,000 for 2013, or $56,500 including the catch-up deferral. Keep in mind that the limits are not per plan but per person: if you participate in another 401(k) plan, the total you can contribute among all plans is $51,000/$56,500.
Increase contributions with a spouse in the plan
While you can't have employees other than yourself in your business and maintain a solo 401(k), the IRS will allow a spouse who works in your business to participate in the plan. The same rules as above apply, so the maximum that could be contributed to a solo 401(k) plan for 2013 is $102,000 if both spouses max out their $51,000 contribution, increasing to $113,000 if both spouses are more than 50 years of age and each takes full advantage of the maximum $5,500 catch-up contribution.
Generally, solo 401(k)s do not have to perform the discrimination testing required in other 401(k) plans as there are no employees who might be subject to inequitable plan benefits. Of course, if you hire employees in the future, you'll trigger discrimination testing and likely have to modify your plan.
While a solo 401(k) plan may seem like an IRA with higher deferral potential, it has one distinct advantage: you can borrow against your solo 401(k), using the plan assets as collateral for the loan. Conversely, accumulated IRA funds cannot be borrowed against, and they can only be distributed without early withdrawal penalties in a few permitted scenarios. While conventional wisdom would caution against borrowing against one's retirement savings, for a self-employed person with a solo 401(k), this may make sense on occasion.
Consider the case of business expansion. Since the credit crisis of 2008, personal and business lending standards have tightened. It's still more difficult to obtain credit than before the recession, and solo entrepreneurs may feel a tighter crimp than larger corporations when seeking a business loan, as the natural up and down cycles that characterize small, developing businesses can make life difficult when approaching a bank for new business lines of credit. A solo 401(k) can provide a bridge loan to the small business owner who may need capital to expand.
The ability to use your solo 401(k) as a temporary financing vehicle for your business can even lower your tax bill. Take a small-business owner who is experiencing short-term tightened cash flow but needs to purchase some new equipment to use in his or her business. A solo 401(k) loan could help pay for the equipment before year-end, which could be then depreciated in full under Internal Revenue code Section 179, delivering a tax benefit come April.
If you are looking for a vehicle to defer income for your self-employment, investigate setting up a solo 401(k) plan in 2014. There's even still time to open a solo 401(k) for 2013 if you hurry, as the plan must be established before year-end. Many brokerages can assist with opening up a solo 401(k) account. Generally, an employee deferral for an incorporated or partnership business must be made before year-end, with the matching employer contribution made by the business's tax filing deadline. In the case of an unincorporated sole proprietor, if you elect to make a 2013 deferral before year-end, you've got until the tax filing deadline in April 2014 to place the money in your account.
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