A Solo 401(k) Offers Attractive Tax Incentives for Small Business Owners

The main question we hear from small business owners is how they can find more ways to reduce their taxable income. A solo 401(k) offers itself as an attractive option when compared to other retirement accounts available. What makes these plans so appealing is their ability to encourage saving for retirement, reduce taxable income, and offer additional flexibility and low administrative burden to other plans.

How Much Am I Able to Contribute?

Each year the IRS sets an annual contribution limit for solo 401(k)s that is indexed for inflation. This limit tells self-employed individuals how much they are able to contribute towards retirement. For 2023, small business owners can contribute up to $66,000 to their accounts. The due date for these contributions is the due date of the tax return, including extensions.

Who is Eligible to Open a Solo 401(k)?

Any self-employed individual with no employees has the ability to open a solo 401(k). There is an exception which allows the owner’s spouse to be employed by the business and still maintain eligibility for this plan. Business owners who operate as a single member LLC or a sole proprietor gain the most benefit out of this plan.

What is Unique to a Solo 401(k)?

Solo 401(k) plans allow the business owner to take advantage of the retirement limits in both an employer and employee capacity. As the employee, you are able to contribute up to $22,500 worry free for 2023. This amount is the same limit the IRS sets on all employees enrolled in a 401(k) plan through their employers.

On the employer side, the contribution limit becomes slightly more restrictive. The 2023 annual contribution limit the IRS will allow is $43,500, however, there is a second limit that we need to consider. The maximum solo 401(k) contribution you can make as the employer is the lesser of: 1) $43,500, or 2) 20% of self-employment income for the year.  This means that if 20% of your self-employment income is higher than the 2023 maximum amount of $43,500, you are entitled to the full contribution for the year. However, if 20% of your self-employment income is less than the $43,500 limit, the lower amount is the maximum amount you can contribute.

What are the Pros and Cons of a Solo 401(k)?

Pros:

1. The amounts contributed to your solo 401(k) are deducted from your income and reduce your tax owed for the year.
2. Even in tight years, business owners can still contribute the employee portion to their accounts.
3. Higher contribution limits than an IRA.
4. Easy to setup and minimal administrative burdens unlike other account plan types.
5. Investment balance grows tax deferred.
6. Flexibility to explore both traditional and Roth accounts.

Cons:

1. S-Corp shareholders may notice a reduced benefit compared to a single member LLC or sole proprietor. S-Corp income is not subject to self-employment tax. Given that the employer portion is contributed as the lesser of 20% of self-employment income or the annual limit, your employer portion will always be zero.
2. Ineligible if the business has employees other than the owner and their spouse.

A solo 401(k) is a highly effective tax saving tool, with the added benefit of saving towards retirement. If you are a small business owner looking for ways to reduce your taxable income, a solo 401(k) is one of the best and easiest tools to take advantage of.

Article by Jarrod Galassi, Senior Tax Manager