2 Important Ways a Solo 401(k) Saves Money on Taxes

What could be better than saving for retirement while cutting your tax burden?

A Solo 401(k) plan is known by a handful of names, including self-employed 401(k), individual 401(k), Solo-k, Uni-k, and one-participant k. Here, we'll refer to this retirement savings plan as a Solo 401(k). A Solo 401(k) is a special retirement savings plan for small business owners who have no employees other than a spouse.

While traditional 401(k) plans offered through larger employers provide a fabulous way to save for retirement, you may find a Solo 401(k) even more attractive. One of the primary benefits of this retirement plan is how much you can save in taxes. Here's how.

1. Save today

Because you own a business, the IRS considers you both the employer and the employee. That works out well for you because it means you can contribute to your retirement plan in two ways.

Employer and employee

With a Solo 401(k), the maximum you can contribute as an employee is $20,500. But here's where savings get ramped up. You're also the employer and, as such, can also contribute up to 25% of your self-employment income.

Better yet, if you're age 50 or over, you can sock away an additional $6,500 in catch-up contributions.

Let's say you're under 50, and your business earns $80,000 in profit this year. Your total eligible Solo 401(k) contribution would be over $35,000. If you're 50 or older, that amount jumps to nearly $42,000.

No matter how much you earn, the most you can contribute to a Solo 401(k) in 2022 is $61,000 if you're under the age of 50. If you're 50 or older, it's $67,500. Keep an eye out, though. Those amounts are set to increase in 2023.

Immediate savings

If you dread tax day each year, tucking income away in a Solo 401(k) retirement plan is a brilliant way to avoid paying too much in taxes.

Again, let's imagine that your small business shows an $80,000 profit. That's $80,000 you would normally have to pay federal, state, and local taxes on (depending on your state). Now, let's say you contributed $30,000 of that profit to your Solo 401(k). Rather than pay taxes on $80,000, you're now only responsible for paying taxes on $50,000.

2. Save later

One of the perks of opening a Solo 401(k) is getting the flexibility to decide when you want to pay taxes on the money you're investing. If you'd rather pay taxes now and make withdrawals tax-free in retirement, you can direct some or all of your contributions to a Roth Solo 401(k). While today's contributions won't reduce your tax burden now, they will save you money later.

One thing to consider as you decide which type of Solo 401(k) you'd like to open is when you believe your tax burden is likely to be greater. Do you believe you're earning more money now than you'll bring in during retirement, placing you in a higher tax bracket? Or, are you planning to have as much (or more) money coming in through your retirement years?

Shop around

No matter which type of Solo 401(k) plan you're most interested in, it pays to shop around. Check with several brokerage firms to learn more about fees and to get a sense of which company makes navigating your Solo 401(k) the easiest.

It's nice to know that it's not just the mega-corporations that can offer 401(k) retirement plans. As the boss of your own company, a Solo 401(k) also makes you the boss of your retirement planning.