For those of you who are working as independent contractors or small business owners, you may benefit from contributing to a small business retirement plan. One plan that allows for the largest pre-tax contribution is the Solo 401(k).
Tax planning for your business may be the difference between turning a nice profit and barely keeping the doors open. Similarly, making smart tax moves may free up more money to save for a secure retirement. Using a Solo 401(k) may allow you to invest more for your future and get some nice tax deductions along the way.
Solo 401(k) Contribution Limits for 2020
With a Solo 401(k), small business owners can contribute as both the employee and the employer. That could lead to some pretty nice tax savings for those who contribute the maximum contribution limit to the plans. As the employee, you can contribute up to $19,500 for 2020. Total contribution limits as both the employee and employer have increased by $1,000 to $57,000 for 2020. That number does not include the potential $6,500 catch-up contribution, available to those who are at 50 years old, or older, during 2020. All in, that means small business owners, who are at least 50 years old, have the option to contribute the maximum contribution limit of $63,500 for a Solo 401(k) plan.
Talk with your financial planner and CPA to find out how much you and your small business can contribute to a Solo 401(k) in 2020. Your actual employer contribution limit will depend on your income and your business structure. As an employee, you can contribute 100% of your income up to the $19,5000 limit. The additional catch-up contribution is only available to those who are 50, or older, at some point in 2020.
What Is A Solo 401(k)?
A Solo 401(k) is similar to the 401(k) or profit-sharing plan you may have if you worked for a larger employer. As the name implies, it is a 401(k) plan specifically designed for individual business owners. A Solo 401(k) can also be advantageous for couples who work together. The Internal Revenue Service (IRS) will prohibit using a Solo 401(k) if you have employees, beyond a spouse.
It is quite popular among high-earning couples. The larger your income limit, the more valuable the tax break associated with a Solo 401(k) plan will be. Likewise, the more you make, the more you can potentially save. Marriage equality has also helped these plans become more popular as of late.
How Does a Solo 401(k) Lower Your Tax Bill?
You will get a tax deduction for each dollar you contribute to your Solo 401(k) plan. That means you will not owe taxes on income at that time. Keep in mind, you will eventually need to pay taxes on the money when you make withdrawals in retirement. The goal would be to take deductions today when you are in a higher tax bracket — paying taxes later when you may be in a lower tax bracket. Funds will need to stay in the retirement account until you reach the age of 59 ½ or your withdrawals will be both taxable and incur an additional 10% early withdrawal penalty.
Why Don’t More People Know About the Solo 401(k)?
While Solo 401(k) plans have grown in popularity during the past few years, they are still not as widely used as other retirement accounts, like a Traditional IRA or SEP IRA. Sadly, one reason for this is that advisors are not allowed to “sell” them and therefore don’t recommend these valuable retirement plans. Another reason could be that some advisors are just lazy and want to avoid the extra paperwork firms require to open these accounts. In my opinion, it is a breach of fiduciary duty to cost a client tens of thousands of dollars in taxes, just to avoid dealing with onerous paperwork.
Before I scare you with thoughts about piles of forms to complete, with many custodians, the amount of paperwork required to open a Solo 401(k) is similar to that of other retirement accounts. From there, the choices about investment options, contribution limits, and associated tax savings make the extra leg work more than worth it. Either way, your trusted financial planner can take care of all of that for you. If not, it is likely time to find a new one.
Running a business is stressful; saving for retirement doesn’t have to be. If it makes sense for you, set up a Solo 401(k) account today for 2020, make automatic contributions on a regular basis and watch your retirement assets continue to grow. You will reach financial freedom before you know it.