A Reader Question Regarding Self Employment Retirement Plans

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A few weeks ago I received an email from someone I affectionately call Blogger X.

In that email, Blogger X asked me for some ideas on how to reduce his taxable income. I decided to write a post addressing some of his concerns and in that post I listed 3 different retirement plans that allow for self employed individuals to shelter gobs of income:

• The Pros and Cons of a SEP IRA
• The Pros and Cons of a SIMPLE IRA
• The Benefits of Owning a Solo 401(k)

Now, the reason I bring all this up is because earlier this week I received a very thorough email (below) from a conscientious reader, and in that email (as you will see) he references the above articles. So, I just want anyone coming across this post to be up to speed;) My answers to his questions are highlighted in blue.

Without further ado…

A question about self employment retirement plans:

Hi Ciaran,

I’ll preface this by saying I read your series on reducing self employed taxable income, and I thought it was excellent. I wanted to know if you can help me better understand my options regarding solo retirement plans. (don’t worry, I won’t hold you to anything… I’m still in the information gathering stage and just looking for info).

My side business. I’m earning decent money with my side business. So far in ‘08 it is just over $3k with accounts receivable of about $800 for April… So let’s say $4k for right now. My goal is $10k on the year. Right now reaching my goal is looking very realistic, but it is possible to even reach as high as $15k if things go very well.

It’s great to hear that your business is growing!

The best part is, right now I don’t need this money for living expenses, so I want to invest as much as possible, and shelter as much as possible from taxes (always a good goal!).

Since your business is continuing to grow and you’re looking to shelter as much as possible, right off the bat it sounds like the Solo 401(k) is an excellent option (especially down the road). The reason I say that is - if you’re self employed - the Solo 401(k) will allow you to put away the most money each year, sheltering it from taxes.

Day job 401(k). My current plan is to max out my 401(k) from my day job. My contributions are set up to do that, and I shouldn’t have a problem reaching it.

Solo 401(k). If I reach the $15,500 401(k) contribution limit for ‘08 from my day job, does that mean I can still invest up to 25% of my self-employment income in a solo 401(k) as profit sharing?

Yes it certainly does, but the actual percentage depends on whether your business is incorporated or not (more on that in a second). In your case, having self employment income allows you to make a profit sharing contribution to your Solo 401(k) plan, and still make salary deferral contributions (up to $15,500 for 2008) through your day job.

IMPORTANT: For 2008, if you have INCORPORATED your business, you can make a profit sharing contribution up to 25% of your pay - not to exceed $46,000. If you are UNINCORPORATED (a sole proprietor), which I believe you are, then your profit sharing contribution can be up to 20% of net income from self employment - not to exceed $46,000.

SEP IRA. I see the max is 20% of self-employment earnings, up to $5,000.

If you are unincorporated, the max for a SEP is 20% of net income (up to $46,000 for 2008). In your case, if you earned $15,000 for 2008, you would be able to contribute $3,000 to a SEP.

In fact, because of the uniqueness of this situation (since you max out your traditional 401(k) contribution), the most you could defer into the Solo 401(k) (in the form of profit sharing) for 2008 would be $3,000, the same as a SEP.

My questions:

#1 -The way I see it, the Solo 401(k) will always allow me to contribute 5% more money than a SEP IRA. Is this correct?

I think you got the notion, “… the Solo 401(k) will always allow me to contribute 5% more money than a SEP IRA” because in my previous posts about the SEP IRA and the Solo 401(k) I actually illustrated two different situations. In the SEP post I illustrated a sole proprietor contribution, in the Solo 401(k) post I illustrated an incorporated business contribution. That’s my fault, it was a bit confusing, I wasn’t consistent.

The Solo 401(k) and SEP actually have the same max dollar amount contribution limits for 2008 - $46,000. Being that you are unincorporated -when it comes to the profit sharing contribution portion of the Solo 401(k), it will be the same percentage as the SEP - 20% of net income.

Where the Solo 401(k) normally kills the SEP is in the salary deferral portion of compensation, but since you have already maxed out the $15,500 through your traditional 401(k) there is no difference in the maximum amount you can contribute.

#2 - Is there any benefit to contributing a larger portion of my self-employment income to the Solo 401(k) vs. contributing to my Traditional 401(k) with my employer? The only difference I can see would be self-employment taxes, but I don’t know how that factors in.

When it comes to the salary deferral portion - you can only make a $15,500 contribution between all your 401(k) plans - total. If your employer is matching your contribution it would obviously makes sense to contribute there. Otherwise, it doesn’t matter whether you contribute to the traditional 401(k) or Solo 401(k).

The amount of self employment tax you pay does factor into how you arrive at your net income earnings number, but once you have the number, all the above rules still apply. (”Net income from self-employment” is defined as Business Income (from line 12 of the 1040) reduced by that business’ share of the adjustment for one-half of self-employment tax paid (from line 27 of the 1040).

I appreciate it if you know the answers to these questions. I just want to shelter as much money as possible from taxes, and I also want to invest as much money as possible for retirement.

Thanks

In your case, since you’re maxing out your traditional 401(k) contribution, it doesn’t matter whether or not you open a Solo 401(k) or a SEP right now. If your situation ever changes and you decide to become fully self employed - know that the Solo 401(k) gives you the ability to put the most away towards retirement.

In the meantime, you can continue to make your traditional 401(k) contribution, make a Solo 401(k) profit sharing contribution (or SEP contribution) and make IRA contributions, as well.

Here’s a nice article I came across that I think will help you even more.

And last but not least, I implore you to review any (and all) decisions with your CPA before acting. Please let me know if you have any further questions:)

Tags: Self Employment Retirement Plans, SEP IRA, Solo 401k