Updated: Apr 23, 2021
There’s still time to save/defer your tax liability for 2020. Here’s a case study as an example of how a self directed solo 401k can help nonemployer business owners and people with 1099 income.
Real numbers case study
This is a case study from an actual client, “Michael”, who is employed by a company that pays him a base W-2 salary (without retirement plan deductions) along with 1099 commissions that are paid to his LLC. Michael is 29 years old, single with no kids, lives in Texas, and adopted his Self-Directed Solo 401(k) plan in December of 2019. When it came time to prepare Michael’s 2019 tax return his CPA ran the numbers to compare his tax liability as if he made no contribution to the Self-Directed Solo 401(k) plan versus making the maximum contribution (see Figure 1).
On the left side you’ll see that Michael’s Business Income from self-employment was $129,404 and he made no Self-Directed Solo 401(k) contributions to the plan, so the Other Adjustments line is blank. Including his base W-2 salary his AGI is $227,492, and his Taxable Income shows as being $215,292. In this scenario, Michael would have a Tax Balance Due of $44,246. His Marginal Tax Rate is 35 percent, and his Effective Tax Rate is 23.34 percent.
On the right side of the table, you’ll see that if Michael contributes $46,714 to his plan, which is the most that he is allowed based on his income, his Taxable Income decreases considerably. His Tax Balance Due plummets from $44,246 to owing the IRS only $25,300. This decreased his tax liability by $18,946, which is a 42.8 percent reduction!
Needless to say, Michael chose to make the maximum contribution to his plan and is enjoying the tax savings. He is also an avid real estate investor, so he can self-direct the $46,714 contribution toward assets that match his preferred investment strategy.
How Michael did it
Michael’s $46,714 contribution consisted of $19,000 (the 2019 limit) as salary deferral + 20 percent of his net earnings from self-employment (Business Income). (Net earnings from his Business Income varies slightly from his gross Business Income listed in Figure 1 due to his business deductions.)
There’s still time to adopt and contribute to a Self-Directed Solo 401(k) plan to save on taxes for 2020, but the amount that can be contributed depends on how the business is taxed.
For 2019 and prior years, the Self-Directed Solo 401k plan had to be established by the end of the tax year. The SECURE Act changed this deadline. Starting with the 2020 tax year, business owners can establish a Self-Directed Solo 401(k) plan up until the tax filing deadline (plus extension) for the preceding year.
Contribution deadlines, however, depend on how the business entity is taxed and the type of contribution being made.
- For Sole Proprietor, Partnerships, and LLCs, the salary deferral and profit-sharing contributions can be made up until the personal tax filing deadline, plus extension.
- For C Corporations and S Corporations, the salary deferral portion must be contributed as the salary to be contributed is earned, within at least seven days, and generally through payroll deductions. Profit-sharing contributions can be made up until the corporate tax filing deadline, plus extension.
Here is more information about the timing to adopt and contribute to a solo 401k for 2020 (and 2021)