SHORTLY AFTER I retired in March 2017, I was asked to consult on some projects. I knew it was going to be a more complex tax year than I’d faced before. I had earned income from my previous employer, pension income and self-employment income from my consulting.
On top of all that, my wife started a new fulltime job the Monday after I retired. We switched to her benefits, but her company didn’t have a high-deductible health plan with an HSA, or health savings account. That meant that, three months into the year, we lost two valuable tax-deductible savings options: my 401(k) and HSA.
Losing those options concerned me. Was there any way to cut our tax bill? I knew there were retirement plans for small businesses, but I wasn’t very familiar with them. I didn’t think we’d meet the income limits to fund an IRA. A SEP IRA—a variation on an IRA intended for small business owners—seemed like a good idea, but I knew little about the accounts. I then discovered a plan that seemed tailor-made for us: a solo 401(k).
A solo 401(k) is like a traditional 401(k) plan, but covers a sole business owner with no employees. One exception: The business owner’s spouse can also participate. The contribution limits for a solo 401(k) are the same as any other 401(k). But with a solo 401(k), the business owner wears two hats: He or she can contribute both as the employee and the employer. Contribution limits for 2019 are:
The definitions of earned income and compensation are important and a little tricky. For employee contributions, you can deduct 100% of “net earnings from self-employment less one-half of your self-employment tax.”
When figuring your contributions as an employer, compensation is your earned income, which is defined as net earnings from self-employment, but with two deductions: one-half of your self-employment tax, plus any solo 401(k) contributions you make as an employee.
You can direct your employee contributions to either a tax-deductible or Roth account. Meanwhile, your contributions as an employer go into a tax-deductible account. If you’re also employed by a second company and participate in its 401(k) plan, contributions to that other plan limit your ability to fund a solo 401(k).
A 401(k) plan is typically required to file an annual report on Form 5500-SF. A solo 401(k) plan, however, is exempt from the annual filing requirement if it has $250,000 or less in assets at the end of the year.
There’s plenty of information online about solo 401(k)s, including from the IRS, financial firms and other sites. I investigated some of the larger firms before choosing Vanguard Group. It was surprisingly easy and inexpensive to set up the plan. It was linked to my other accounts, so I could see my entire holdings with one logon. And because we were established customers, Vanguard waived the annual account fee. With my solo 401(k), I can invest in all of Vanguard’s mutual funds.
The account must be opened by Dec. 31 if you want to contribute for the current tax year, but you have until the April 15 tax-filing deadline to make contributions. This turned out to be helpful. In my first year, most of my consulting income came in the fourth quarter. I used the 401(k) contribution to tailor our tax bill. Using TurboTax, I computed a number of tax returns with different contribution amounts until I achieved a final tax owed that we were comfortable with. I was happy to have this “dial” to turn, as I fine-tuned our tax bill.
The following year—2018—my income varied even more. I had less self-employment income from my business, but picked up some more as a part-time employee for a small business. Again, a significant portion of my income came in the fourth quarter. This variability made tax planning a bit more complicated. In 2018, we were able to defer virtually all of the self-employment income to limit the tax owed. Note that income from working full- or part-time for another business doesn’t count when computing the maximum allowable solo 401(k) contribution. Instead, you need to be working as a contractor, with income reported to you on Form 1099.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include What Number, Taking Your Lumps and Quiet Heroism. Follow Rick on Twitter @RConnor609.