If you filed an extension for your 2020 taxes, there may still be a tax deduction option available if you are eligible to adopt a self-directed solo 401(k).
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 adopt a self-directed solo 401(k) plan up until the tax filing deadline (plus extension) for the preceding year. That means that if a plan is established and contributed to, per the contribution rules outlined below, before the tax return is filed, then you can take advantage of a great tax and retirement savings opportunity.
Contribution types – the difference matters for timing
The Self-Directed Solo 401(k) allows for pretax contributions to be made two different ways: Salary Deferral and Profit-Sharing. Here is the 2020 contribution limit breakdown for each and how they are calculated.
*Salary Deferral - With salary deferral, the account holder can contribute:
- 100% of net earnings from self-employment up to a maximum of $19,500.
- Those who are 50 years old or older qualify for the additional catch-up contribution of $6,500, bringing the salary deferral limit to $26,000.
Profit-Sharing - In addition to salary deferral, the account holder can also make a profit-sharing contribution:
- For those set up as an LLC, Partnership or Sole Proprietor, they can contribute up to 20 percent of their net earnings from self-employment.
- Those set up as C-Corporations and S-Corporations can contribute up to 25 percent of their salary from self-employment.
Combined Limit - The contribution limit for the salary deferral and profit sharing, combined, cannot exceed $57,000 for those under 50 years old or $63,500 for those 50 years old and over. Again, this is the maximum amount allowed for 2020; the account holder doesn’t have to contribute the full amount.
Contribution deadlines depend on how the business entity is taxed and the type of contribution being made.
For Sole Proprietor, Partnerships and LLCs, 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. This means that it is too late to make salary deferral contributions for 2020 because the money to be contributed has long-since been earned. Profit-sharing contributions, on the other hand, can still be made up until the corporate tax filing deadline, plus extension.
With the September 15th and October 15th extension deadlines fast approaching, it is advisable to start the process to establish the plan as soon as possible and then make the contribution since it will need to be recorded on your 2020 return.
Since the plan will be established, you can also start making contributions for 2021 to continue the tax savings and increase the investable funds over time.