The 12 Tax Days of Christmas: Day 3 Exploring the Solo 401(k) strategy.
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Rather than your true love sending you a partridge in a pear tree, wouldn't you appreciate some money-saving tax tips? For my year-ending 12 Tax Days of Christmas series, I'll dig back into the archives of previous topical columns to reiterate understandable, realistic and legitimate tax strategies that you need to implement now in order to have a much smaller tax bill come April 15.
For this third tax day of Christmas, let's turn our attention to how more and more small-business owners are discovering the power of the Solo 401(k). If you don't have non-owner full-time employees, it could be a perfect fit for you to obtain some huge tax write-offs and build your nest egg for the future. Now, to be clear, the definition of a Solo 401(k) and those who can participate is much broader than many people realize. A Solo 401(k) actually allows for your spouse and children to participate in the plan, and if you have a business partner, it includes their spouse and children. But again, if there are other full-time employees in the organization, the company will have to adopt a "group plan" (typically a safe-harbor plan).
The beauty of the Solo 401(k) is that it can be set up quickly and more affordably, which is why it makes the list of year-end strategies covered in our 12 Tax Days of Christmas.
New Solo 401(k) Set-Up Deadline is 12/31/19
First, in order to make 2019 contributions, the Solo 401(k) must be adopted by your business by December 31, 2019. If you haven't already adopted a Solo 401(k) plan, you should start now so that documents can be completed and filed in time. If the 401(k) is established on January 1, 2020 or later, you cannot make 2019 contributions.
As 2019 comes to an end, it is critical that Solo 401(k) owners understand when and how to make their 2019 contributions. There are three important deadlines you must know if you have a Solo 401(k) or if you still plan to set one up in 2019. A Solo 401(k) is a retirement plan for small-business owners or self-employed persons who have no other full-time employees other than owners and spouses. It's a great plan that can be self-directed into real estate, LLCs or other alternative investments, and allows the owner/participants to contribute up to $56,000 per year (far more and faster than any IRA).
Related: The 12 Tax Days of Christmas -- Day 1
2019 Contributions Can Be Made in 2020
A wonderful benefit of the Solo 401(k) is that you get the tax deduction in now, but both employee and employer contributions can be made up until the company's tax-return deadline next year, including extensions. If you have an S corporation or partnership LLC, the deadline for 2019 contributions is March 15, 2020, or even as late as September 15m 2020 when filing a valid six-month extension. This a huge benefit for those who want to take a 2019 deduction, but won't have funds until later in the year to make the actual contributions.
W-2s Force You to Plan Now
While your contributions may be extended until the company tax-return deadline, you will need to file a W-2 for your wages (e.g. an S corporation) by January 31, 2020. The W-2 will include your wage income, and any deduction for employee retirement-plan contributions will be reduced on the W-2 in box 12.
As a result, a business owner should at least determine the amount they plan to contribute so they can file an accurate W-2 by January 31, 2020. Again, if you don't have all or a portion of the funds you plan to contribute, you can do so later, but the IRS requires that you at least "designate" and report your plan or intentions and stick to them. Failure to do so could result in serious penalties, or at the very least the cost of amending tax forms later.
An Example
Now let's bring this all together and take an example to outline how this may work. Sally is 44 years old and has an S corporation for her online business. She is the only owner and only employee and had a new Solo 401(k) established in 2019. She has $120,000 in net income for the year and will have taken $50,000 of that in wage income that will go on her W-2 for the year. That will leave $70,000 of profit that is taxable to her and that will come through to her personally via a K-1 from the business. Sally has not yet made any 2019 401(k) contributions, but plans to do so in order to reduce her taxable income for the year and to build a nest egg for retirement. If she decided to max out her 2019 Solo 401(k) contributions, it would look like this:
- Employee Contributions: The 2019 maximum employee contribution is $19,000. This is dollar for dollar on wages so you can contribute $19,000 as long as you have made $19,000. Since Sally has $50,000 in wages from her S corp, she can easily make a $19,000 employee contribution. Let's say that Sally doesn't have the $19,000 to contribute, but will have it available by the tax-return deadline (including extensions). What Sally will need to do is let her accountant or payroll company know what she plans to contribute as an employee contribution so that it can properly report the contributions on her payroll and W-2 reporting. By making a $19,000 employee contribution, Sally has reduced her taxable income on her W-2 from $50,000 to $31,000. At even a 20 percent tax bracket for federal taxes and a 5 percent tax bracket for state taxes, that comes to a tax savings of $4,750.
- Employer Contributions: The 2019 maximum employer contribution is 25 percent of wage compensation, not to exceed $56,000 total. Since Sally has taken a W-2 wage of $50,000, the company may make an employer contribution of $12,500 (25 percent of $50,000). This contribution is an expense to the company and is included as an employee-benefit expense on the S corporation's tax return (form 1120S). In the stated example, Sally would've earned $70,000 in net profit/income from the company before making the Solo 401(k) contribution. After making the employer-matching contribution of $12,500 in this example, Sally would then only receive a K-1 and net income/profit from the S corporation of $57,500. Again, if she were in a 20 percent federal and a 5 percent state tax bracket, that would create a tax savings of $3,125. This employer contribution would need to be made by March 15, 2020 (the company return deadline) or by September 15, 2020 if the company were to file an extension.
In the end, Sally would have contributed and saved $31,500 for retirement ($19,000 employee contribution, $12,500 employer contribution), and she would have saved approximately $7,750 in federal and state taxes. That's a win-win.
Related: The 12 Tax Days of Christmas: Day 2
Set Up a Plan That Allows for Self-Directing
There are 28 trillion dollars in retirement plans in the United States. Do you know that these funds can be invested into all sorts of businesses or assets other than stocks, bonds and mutual funds? Yes, it's true, and a Solo 401(k) can be used to invest in startups, private companies, real estate and small businesses. Unfortunately, most entrepreneurs and retirement-account owners didn't even know that retirement accounts can invest in private companies, but you've been able to do it for more than 30 years.
If your account is with a typical IRA or 401(k) company -- such as Fidelity, Vanguard, TD Ameritrade, Merrill Lynch, Charles Schwab -- then you can only invest in investments allowed under their platform, and these companies deem private company investments as "administratively unfeasible" to hold, so they won't allow your 401(k) to invest in them (some make exceptions for ultra-high net-worth clients, e.g. $50 million-plus accounts). As a result, the first step when setting up a 401(k) is to decide if you want to "self-direct'" or just place your money in typical Wall Street funds or structures. If you want a self-directed 401(k) with both traditional and Roth options, speak with an independent law office that isn't associated with a broker-dealer or national bank.
Our offices at KKOS Lawyers have been setting up self-directed Solo 401(k)s for years. Shop around to find the right plan that will meet your needs, and keep in mind, you need to start making plans now and will want to begin coordinating with your accountant or payroll company. Your yearly wage information on your W-2 (self-employment income for sole props) is critical in determining what you can contribute to your Solo 401(k).
Also, make certain you have the plan set up in 2019 if you plan to make 2019 contributions. While IRAs can be established until April 15, 2020 for 2019 contributions, a Solo 401(k) must be established by December 31, 2019 if you want to make 2019 contributions. Don't get the two confused, and make sure you've got a plan for your specific business.
