Tax-Free Income: Solo 401(k) Plans

As tax reform comes into focus, the 401(k) plan -- a stalwart of savings in the investment community -- is reportedly on the chopping block, creating a mild panic for traditional W-2 employees. For taxpayers who take on the risk of self-employment, however, the ability to contribute to a 401(k) plan as both employee and employer provides a unique opportunity to work around the currently proposed changes.


Last week, the IRS announced 2018 contribution limits for pension plans, including an increase in total 401(k) contributions an employee can make, from $18,000 in 2017 to $18,500 in 2018.

Meanwhile, Congress has been busy putting together a budget for fiscal year 2018, a measure that passed in the House this week. The Senate is now discussing their version of the bill, and the 'word on the street' is that 401(k) plans, while retaining their annual contribution limits, are going to be restricted in terms of pre-tax contributions. Specifically, of the $18,500 contribution an employee can make into a 401(k) plan, only $2,400 can be contributed to a pre-tax account; the remainder can only be contributed to a Roth (after-tax) account.

For the W-2 employee with a 401(k) plan, the ability to defer taxes until retirement is hampered considerably by the proposed change to pre-tax contributions. For someone with an effective 20 percent tax rate, the loss in current tax savings equals ($18,500 - $2,400) x 20% = $3,220.

However, for a self-employed taxpayer on payroll (with no other common law employees), the savings potentially lost on the employee side can be made up on the employer side with the help of a Solo 401(k) plan.

With a Solo 401(k) plan, a taxpayer can contribute up to $55,000 (in 2018, up from $54,000 in 2017) into retirement:

  • the annual employee contribution limit of $18,500 (in 2018, up from $18,000 in 2017), plus

  • the employer contribution, equal to an amount up to 25 percent of compensation to the employee, with aggregate contributions not exceeding the total contribution limit ($55,000 for 2018, $54,000 for 2017).

Currently, the employee contribution can be all pre-tax, all after-tax (Roth), or a combination of both. The proposed changes will limit the amount of pre-tax contributions considerably, all but forcing taxpayers to 'Rothify' their retirement.

Currently, the employer contribution can only be pre-tax. The employer contributions, then, are the natural remedy to offset the savings lost as the employee.

For example, in 2018 a single-member S corporation pays its officer a salary of $60,000. The taxpayer, able to act as both employee and employer, can:

  • contribute up to $18,500 into a pre-tax account, an after-tax account, or a combination of both (as employee), and

  • contribute up to ($60,000 x 25%) = $15,000 into a pre-tax account (as employer).

Thus, if the taxpayer contributes all $33,500 into a pre-tax account, that translates into current-year tax savings of $6,700 (at an effective rate of 20 percent).

In the event that the taxpayer is precluded from contributing the full employee portion to a pre-tax account, the taxpayer can still lock in pre-tax savings through the employer contribution:

  • contribute up to $2,400 out of $18,500 into a pre-tax account, and the remainder into a Roth account (as employee), and

  • contribute up to ($60,000 x 25%) = $15,000 into a pre-tax account (as employer).

In order to hedge the risk of short-term versus long-term tax rates, as well as the risk of taxable-income-now versus taxable-income-later, a balanced 401(k) account (with weighted pre-tax and after-tax allocations) is recommended. Thus, while the savings outlook for traditional W-2 employees appears to be heading for extreme Rothification, the opportunities for risk-tolerant entrepreneurs is relatively undisturbed.

If you are thinking about capitalizing on the potential of a Solo 401(k) plan and want to reduce investment expenses, consider Vanguard's DIY 401(k) enrollment kit, which makes set up and administration easy for the self-employed taxpayer (with no common law employees). It should be noted that not all financial institutions offer a Roth 401(k) option. Vanguard does offer a Roth 401(k) option.

I am not an investment advisor, nor do I receive any fees from Vanguard or any other financial or investment firm. I provide professional tax services that focus on savings opportunities, especially for S corporations with one shareholder / employee. As the IRS requires S-corporation shareholder / employees to take "reasonable compensation" in the form of payroll, the leveraging of that income through a Solo 401(k) plan is an obvious tax move.

For investment advice, please contact your financial advisor.



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