Mark Zaifman's thoughts on Money, Global Economic Trends and Politics

The 3 Major Benefits of a Solo-401k Plan for Your Small Business

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If you’re looking for a way to max out your contributions to a deductible retirement account, the solo 401(k) plan is an option to strongly consider.

With a solo 401(k), you can contribute your maximum annual contributions like you would to any other 401(k) plan; $17,000 of your 2012 compensation or self-employment income ($22,500 if you’ll be 50 or older at year-end.)

But here’s the real ‘sweet spot’ for this option. You can contribute and deduct an additional amount of up to 25% of your compensation income, or 20% of your self-employment income.

Below is an example of how this works. And by the way, to be eligible for the solo 401(k), the assumption is you’re the only employee of your business, corporation, LLC or PLLC or it’s you and your spouse or you and your office manager/assistant. You can of course hire independent contractors and still qualify.

Boost Your Savings

You own Fun Inc. (FI) and in 2012 FI, your corporation, plans to pay you $100,000 in annual salary. You’re 53, so you’re eligible for the catch-up contribution as well, so for this year, your 401(k) salary deductions to your solo plan will total $22,500.

And here’s where the solo plan boosts your savings amount even more. In addition to your annual salary deferrals totaling $22,500, your company can also make profit sharing and matching contributions on your behalf as well for up to 25% of your salary, offering you an opportunity to invest up to $47,500 total for 2012 in this example:

{$22,500-salary deferral+(25% profit sharing & company match of $100,000)}= $47,500

Big Tax Savings Potential

Take it a step further and say you’re in the combined Federal and State tax bracket of 40% for 2012. Your potential tax savings for 2012 would be $19,000. And yes, you read that correctly. In this hypothetical example, by combining your total salary deferral contributions with your company’s 401(k) match along with a profit sharing contribution, you are potentially paying $19,000 less to the IRS and state tax authorities:

$47,500(total salary deferral and company contribution) x 40% (tax rate) = $19,000

For 2012, the combined company and salary deferral solo 401(K) maximum contribution amount is $50,000 or $55,500 for 50 or over.

3 Major Benefits of a Solo 401(k) Plan

When I put my strategic tax planning hat on, I’m constantly on the lookout for optimal tax strategies that are nimble and flexible as much as they are savvy.

• One of the major benefits of the solo 401(k) plan is the flexibility it offers in terms of annual contributions. While some plans, especially defined benefit plans require mandatory minimum contributions each year regardless of cash flow or projected profit, the solo 401(k) plan  allows you flexibility in terms of your annual contributions. And from a tax planning perspective, being able to align your retirement planning strategy with your tax planning strategy, well that’s a winning combo you’ll find hard to beat.

• Major benefit number two – During the boom years when cash is flowing like a mighty river and profits are strong, the solo 401(k) plan is your ticket to major tax savings. You’ll reap those savings by maxing out your contribution to your solo plan which in return will significantly lower your tax bill for your current tax year. This strategy is simple and straight forward: Max out your solo 410(k) contributions in the cash flow positive years, save big money on taxes as a result, then reinvest those savings in your practice or business.

Creating significant tax savings in the cash flow positive years, while providing you the option to contribute less (or zero) in the lean years, when conserving cash is your highest priority.

• Major benefit number three – Many small business owners usually start off with a Simple IRA plan for their business, even when the practice or business is a solo venture. There are many reasons for this, the main one being the simplicity of establishing this type of retirement plan. Yet what very often happens is that your income grows significantly over the years and you end up outgrowing your Simple IRA plan, never exploring alternatives.

When you compare a Simple IRA retirement plan where the maximum contribution in 2012 for age 50 or over equals $14,000 and contrast that with a solo 401(k) plan, maximum contribution for age 50 or over equals $55,000, it’s no contest.

This may sound odd, especially considering I majored in tax accounting during college; I feel good overall about paying my fair share of taxes. And the more I make, the more I ought to pay.  That doesn’t mean I will not use the knowledge I gained to play the tax game in a smart and sensible way as illustrated in the above example.

But tax policy at its core is about the type of society we all want to live in. It’s about fairness and it’s about paying it forward for the next generation.  Watch Elizabeth Warren, hopefully our next Senator from the great state of Massachusetts say it best:   

As a registered investment advisor, we can establish and manage your solo-401(k) plan through our institutional custodian, Charles Schwab.

Let us help you become a smart and savvy small business owner today.

Image credit http://www.flickr.com/photos/xoconostle/

Solo 401(k) A Smart Tax Saving Strategy for the Solo Entrepreneur

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For most small business owners, discussing the pros and cons of a pension plan vs. a 401(k) vs. a SEP IRA is about as exciting as watching paint dry. I get it. Yet, I’ve noticed over the years just how much time entrepreneurs invest in growing their business and how little time and money they spend on designing smart and sensible tax savings strategies that could save them big money at the end of the year.

Welcome to the Solo 401(k) plan.  This came about in 2002 after Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001. This option allows the solo business owner an opportunity to not only defer taxes but to save and invest more money than they could in a SEP IRA plan, all things being equal.

My Client Saved Over $8k in Federal and State Income Taxes

Here’s how it worked. I started working with Client X almost 2 years ago. She lives in the Bay Area and owns a very successful business. When I first reviewed her financial data, I noticed she was using a SEP IRA to fund her retirement. As part of my review during the financial planning process, I compared her SEP maximum contributions to that of a Solo-401(k) and guess what I discovered? By using a Solo-401(K) for her retirement as opposed to her current SEP-IRA, she was able to save approximately $8,000 on Federal and State income taxes.

Although she had a tax preparer that, in my opinion, should have recommended this retirement strategy back in 2002, in all fairness to the tax preparing profession, their main objective is to prepare and submit your tax return to the proper authorities with zero errors. Tax planning and tax strategies can be, but are often not included in tax preparation services.

Here’s How it Worked

Instead of providing actual client numbers, let’s assume Client X had net-income from her business of $115k for 2009. Let’s also assume Client X is in her early 60’s and she operates her business as a sole proprietorship. With her SEP-IRA, the maximum tax deferred contribution she can make is $23,000. One major negative of the SEP-IRA (for those age 50+) is that there isn't an additional $5,500 catch-up contribution provision like there is with the Solo 401k.

Who Would Benefit From Using a Solo 401k?

Here's how the calculation works. In 2009 and 2010, participants in a Solo 401k can contribute up to 100% of the first $16,500 ($22,000 if age 50+) of W-2 compensation or net self employment income for a sole proprietorship. In addition, a profit sharing contribution can be made up to 25% of W-2 wages or 20% of net self employment income. The contribution limit calculation in a Solo 401k is important because it allows you to potentially save more than a SEP IRA at the same income level.

Following my recommendations, Client X used the Solo 401(k) and contributed a total of $45,000 into her retirement plan for 2009 as opposed to the maximum $23,000 available through a SEP-IRA. Based on her income tax bracket, she saved $8,000 in Federal and State Income taxes.

What about you? Are you taking advantage of the latest money saving tax strategies? If you are a small business owner, you may want to reconsider your options.

Photo credit http://www.flickr.com/photos/solo_with_others/