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When to Open Your Solo 401(k) to Maximize Tax Benefits

A self-directed Solo 401(k) is one of the best retirement plan options for independent entrepreneurs.

With a self-directed Solo 401(k), you can invest in anything the IRS rules allow for, including real estate, venture capital, cryptocurrency and more.  Being able to invest in what you know is a game changer when it comes to protecting and growing your nest egg.

But where a Solo 401(k) really stands out is when it comes to contributing to your plan.  A Solo 401(k) allows you to supercharge your retirement savings by setting aside up to $61,000 per year if you are under age 50, and $67,000 if you are age 50 or older (as of 2022).

If you are considering establishing a new Solo 401(k) plan for your business, paying attention to the calendar can be important.  For some investors, there is a big benefit to having a plan setup sooner rather than later.

How are you Compensated?

All 401(k) contributions must come from compensation received from the employer.  There are two types of compensation, depending on the business format.

In a sole proprietorship, LLC, or partnership, it is most common for income from the business to be classified as “pass through” to the owner.  This means that all net income from the business is considered income to the owner(s) of the business.

In a S-Corporation, C-Corporation, or an LLC that has taken a “corporate tax” election, all income does not pass through to the owner as compensation.  As an employee of your own business in this scenario, you will receive W-2 wages.  Some income can be classified as shareholder distributions and therefore not subject to payroll taxes for Social Security and Medicare.  Only the W-2 wages are considered compensation for purposes of 401(k) contributions.

The formulas for determining your potential 401(k) contributions depend on how your compensation is defined.

Two Types of Contributions

Solo 401(k) plans allow for contributions from the employee and the employer.  If you have an owner-only business, you are considered the employee of your business for purposes of 401(k) contributions.

Employee Contributions

As the employee, you can contribute up to the individual limit based on your compensation from your business.  As of 2022, the limit is $20,500 for individuals under age 50.  Savers who are age 50 or older can add a “catch up” contribution of $6,500, bringing the total to $27,000.

For a business owner in a pass-through entity, compensation is the net income of the business.  For someone with a corporate tax structure W-2 wages are the compensation that can be used.

You can contribute 100% of compensation up to the individual limit.

Employer Contributions

Your business can also make a profit-sharing contribution to the plan.

In a W-2 compensation environment, an employer contribution of up to 25% of wages is allowed.

In a pass-through environment, the calculation is more complex.  The maximum allowed is 20% of allowable compensation, which is net business income less 50% of your self-employment taxes.

Solo 401(k) Plan Establishment Deadline

Prior to passage of the SECURE Act in 2019, a Solo 401(k) had to be adopted on or before December 31st to be able to accept contributions for that year.

The SECURE Act extended this deadline to the tax-filing date of the business, including extensions.

But here is the big caveat.  A plan established in the year after the taxable year can only accept employer contributions for the prior year.

If you establish a new Solo 401(k) between January 1st and your tax filing date, you cannot make employee contributions for the prior year.  That can dramatically reduce the amount you are able to set aside into your plan.

Eligible Compensation

Even if you setup your plan before December 31st, your ability to make contributions may be limited depending on your business’s tax structure.

Employer profit sharing contributions can look to all income received since the beginning of the plan year.  So, even if you setup your plan in December, you can make an employer contribution based on all your income for the year.

That is not the case with all employee contributions, however.

In a sole proprietorship / pass-through environment, you do not have “payroll”, per se.  You get paid when you file your tax return and determine your income for the year.  As such, you can look at the entire tax year back to January 1st when calculating your compensation for purposes of employee contributions.

If you pay yourself a W-2, timing matters.  Employee contributions are linked to payroll processing and must be made within about 7 days from the end of a pay period.  As such, you can only contribute based on wages received after your plan is setup, and must make your final year-end payroll contribution by about January 7th.

If you setup your plan on December 1st, you can only make employee contributions based on your wages received after that date.  Some people setting up a plan late in the year may choose to pay themselves a year-end bonus to allow for a larger plan contribution.

The Bottom Line

If you are a sole proprietor, there are advantages to having your plan setup by December 31st.  You can make full employee and employer contributions for the year of plan establishment and can do so up until your business tax filing date, including extensions.

If you have a corporation and pay yourself a W-2 wage, timing is more critical.

You can make a full employer profit sharing contribution for the year, whether you setup your plan in the current year or by your business tax filing date.

Employee contributions can only be made based on wages received after the plan is established, and must be made by about January 7th.  Establishing your plan in advance of year end will give you more of an opportunity to contribute for the current year.

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