Solo 401(k) at high income

In short

A friend of mine sold his company, kept consulting on the side, and called me last spring wondering where his tax savings had gone. If you are earning a lot from your own business and have no employees, a Solo 401(k) is a plan worth knowing about. It lets one person act as both the employee and the employer, and that means two separate pockets to fill. The employee pocket holds up to the current figure, which the official source publishes each year this year. The employer pocket holds a percentage of your pay, and the combined total is capped at the current figure, which the official source publishes each year. The plan has to be open by the end of your tax year, even though some money can go in later. Look up your own numbers on the IRS pages before you move a dollar.

The whole of it

What it is

I once watched a neighbor of mine, a carpenter with a good head for figures, try to explain his retirement account to his brother. He kept saying he was both the boss and the worker, and the brother kept laughing. But he was right. A Solo 401(k) is a retirement plan built for a business owner with no employees other than a spouse. The owner wears two hats. As the worker, you defer part of your pay. As the business, you add a share of the profit.

You have probably heard these called one participant plans, and that is a fair name. The IRS describes them on its pages for retirement plans for self employed people. The rules are the same ones that govern a regular 401(k), just fitted to a plan of one.

This matters most when income is high. A salaried worker with a big paycheck often hits a wall, because the employer plan is capped and the match is small. A founder who owns the business can often put away far more. That is not a loophole. It is how the law treats a person who is both the owner and the only staff.

How it works

If you are running a business of your own, picture two buckets sitting side by side. The first is the employee bucket. You choose how much of your pay to defer, up to the yearly limit, which is the current figure, which the official source publishes each year. If you are age 50 or older, the law lets you add a catch up amount of the current figure, which the official source publishes each year on top.

The second bucket is the employer bucket. The business may add a percentage of your pay. For a corporation, that is a percentage of your W-2 wages, and the IRS sets the top rate at the current figure, which the official source publishes each year. For a sole proprietor, the math runs off net self employment earnings and comes out a bit lower, because the IRS requires a special adjustment. The IRS Publication 560 walks through it.

Both buckets together cannot pass the overall cap, which is the current figure, which the official source publishes each year before any catch up. That is the ceiling, and no amount of extra income lifts it.

Here is a point that trips up many founders. The plan itself has to exist by the last day of your tax year. The employer share can often be paid in after the year ends, up to the tax filing deadline, but the employee deferral generally has to be elected during the year. Missing that date can cost a whole year of savings. So if you are reading this in the fall, open the plan now.

There is one more door worth knowing. Many plans let you make Roth contributions, which are taxed now and grow tax free. Others keep everything pre tax, so you get the deduction now and pay later. Which one a plan offers depends on the plan document, so ask the provider before signing.

The numbers, and where to find yours

Here is where I ask you to slow down. Every figure that changes each year lives on an official page, and I would rather you read it there than trust my memory.

The employee deferral limit is the current figure, which the official source publishes each year. The overall cap is the current figure, which the official source publishes each year. The catch up amount for those 50 and older is the current figure, which the official source publishes each year. The employer percentage is the current figure, which the official source publishes each year. The IRS posts all of these on its page called 401(k) Plan Overview and in its yearly announcement of cost of living changes to retirement plan limits.

Your own numbers come from your own books. If you run a corporation, find your W-2 wages. If you are a sole proprietor, find your net earnings from self employment on Schedule C and Schedule SE. Your tax preparer can give you the adjusted figure in about ten minutes. Write it down.

One last place to look is the yearly filing for a plan of one. The IRS has said that a one participant plan with assets above a set amount must file an annual return, and the form has changed over the years. The IRS names the current form and the asset threshold on its pages for one participant plans, so check there rather than guessing.

A worked example

A woman I will call Dana runs a design studio as an S corporation. She has no employees. She pays herself a W-2 salary of $200,000 this year, and the business has plenty of profit left over. She is 46 years old.

Dana wants to know how much she can set aside. For this story, her plan allows an employee deferral of $23,000 and an employer rate of 25 percent. These are made up figures for the example, not the current law, so Dana should check the IRS pages for her year.

Her employee deferral is $23,000. Her employer contribution is 25 percent of $200,000, which is $50,000. Add them together and the total is $23,000 plus $50,000, or $73,000.

Now she checks the overall cap. In this example it is $69,000, another made up figure. Her $73,000 is over the cap by $4,000, so the plan will not accept it. She trims the employer share to $46,000, because $23,000 plus $46,000 is $69,000. That fits.

Notice what happened. Her salary was high enough that the cap, not her pay, set the limit. Had she paid herself only $60,000, the employer share would have been 25 percent of $60,000, or $15,000. Then $23,000 plus $15,000 comes to $38,000, well under the cap. So in that case her pay was the limit.

That is the lesson Dana took home. At a high income, the cap decides how much goes in. At a modest income, your pay decides. Know which side you are standing on.

Where it goes wrong

I have seen smart people stumble here, and none of them were careless. They were busy. The first stumble is missing the date. The plan has to be set up by the end of the tax year. A founder who waits until April to open one may find the year already closed.

The second is hiring help. A Solo 401(k) is built for a plan with no employees other than a spouse. Once a business hires a worker who qualifies for the plan, the rules shift, and the plan generally has to cover that person too. Check with your plan provider before you hire.

The third is mixing up the two buckets. Some people think the cap applies to each bucket on its own. It does not. The cap covers both together, which is exactly what Dana found out.

The fourth is the sole proprietor adjustment. The employer share is not a flat percentage of net profit. The IRS requires a reduction, and skipping it can mean an excess contribution. An excess has to be corrected, and the corrections cost money and time.

The fifth is a plan that charges more than it should. Some providers add fees for a plan of one. Ask what the yearly cost is, in dollars, before you sign. Small fees compound over twenty years the same way small returns do.

And the last is going it alone on the tax filing. A plan with assets over the IRS threshold has to file an annual return, and the IRS names the current form on its one participant plan pages. Forgetting it can bring penalties. A good preparer will keep track of this for you.

Questions to answer before you leave this page

Have you looked up this year's employee deferral limit, overall cap, and employer percentage on the IRS pages, and written them where you can find them again? Do you know whether your business is a corporation or a sole proprietorship, and which pay figure feeds the employer share? Is your plan opened, or will it be opened, before the last day of your tax year? Are you 50 or older, and if so, have you counted the catch up amount? Does your provider offer a Roth option, and do you know the difference in how it is taxed? Have you asked what the plan costs each year in dollars? Do you plan to hire anyone, and have you asked how that would change the plan? And have you sat down with a tax professional who can run your own numbers, so that your story ends better than my friend's began?