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57. Tax optimization with 401K Solo MUST have payroll!

Get ready to launch a solo 401(k) retirement plan

Most contributions and other limits for retirement plans only budged slightly for

2020. But some small business owners can take matters into their own hands.

Strategy: Set up a "solo 401(k) plan." If you qualify, you can effectively benefit from

both "employee" and "employer" contributions to your account. In many cases, this

dual tax winner can't be beaten because it often allows you to sock away more money than any other type of retirement plan.

Here's the whole story: With the standard defined contribution plan used by small business owners—such as a Simplified Employee Pension(SEP) or garden-variety profit sharing

plan the employer's deductible contribution in 2021 is capped at the leséer of 25% of compensation or $58,000.

The maximum compensation that may be taken into account for these purposes is $290,000. But that's as far as it goes.

In contrast, an employee participating in a traditional 401(k) plan can make an elective

deferral contribution to the plan within the annual limits and the employer may match

part of the contribution, usually up to a single-digit percentage of your salary.

A solo 401(k) offers even more. For 2021, you may defer up to $19,500 of compensation

to your account, plus an extra catch-up contribution of $6,500 is allowed if you're age 50

or older—the same as with elective deferrals to a traditional 401(k). Of course, the limits

on deductible employer contributions still here's the kicker: Elective deferrals

to a solo 401(k) don't count toward the 25% cap. So you can combine an employer contribution with an employee deferral for greater savings.

Example: Big tax winner for a small business owner

Let's say you're the sole employee of your company, you're under age 50 and you receive

an annual wage of $125,000. The maximum deductible amount you may contribute to a

SEP is $31,250 (the lesser of 25% of compensation or $58,000). If you set up a solo 401(k)

plan. instead, you can defer $19,500 to the account in addition to keeping the maximum

$31,250 employer contribution. That gives you a total contribution of $50,750 (below the $58,000 limit). And, since you're the only employee of the company, you don't have to

worry about making contributions for anybody else.

The contributions to a solo 401(k) grow tax-deferred until you're ready to make withdrawals.

For simplicity, suppose you contribute $50,750 to your account each year for the next 20 years until you retire. If you earn 7% a year, you will have accumulated a whopping nest egg worth $2,226,158!

Conversely, if you contribute $31,250 to a SEP for 20 years instead and invest it at the same

7% rate, you will accumulate $1,281,109 before retirement—or $944,849 less.

If the business isn't incorporated, the 25%-of- compensation cap on employer contributions is reduced to 20% because of the way contributions are calculated for self-employed individuals. But that still leaves you with plenty of room to maneuver.

For instance, if your net self-employment income is $125,000, you can stash away up to

$44,500 ($19,500 deferral and $25,000 employer contribution) in the account this year.

And remember that contributions can be boosted once you reach age 50.

Note that a solo 401(k) may offer other advantages. For instance, the plan can be set up

to allow loans and hardship withdrawals. Also, you might roll over funds tax-free from another qualified plan if you previously worked somewhere else.

Tip: Contributions are discretionary. Therefore, you can cut back on your annual co ablution—or skip it entirely—if your business is having a bad year.

Going solo: Not a 'free ride'

Despite the obvious benefits, there are a couple of drawbacks to solo

401(k) plans.

  1. If your business has any other employees, they may have to be covered under the plan.

  2. You have to deal with the hassle and cost of running the plan. Good news: After the tax rules were changed to favor solo 401 (k) plans, more "big players" entered the arena. Now that financial outfits like Fidelity and Smith Barney offer solo 401 (k)s, administrative costs have plummeted. Typically, a small business owner might be charged a one-time setup fee of$100 and a small annual administrative fee ranging from $50 to $250.


Tax Preparation, Payroll, Accounting, Tax Planning

Call us at (800) 913-0809 or send an SMS (224) 676-3577 if you have any questions.

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