One of the key purposes of owning a business should be to build wealth using the tax advantages that business owners have access to that most W2 employees do not.
If you are the 100% owner of a business, and you are the only employee in the business, there is a game-changing, wealth building advantage available to you that very few people have. If this situation applies to you, this may be the one narrative you read this year that has the single most profound impact on wealth building in your lifetime. One-employee business owners can save significantly more for retirement each year, at a lower cost and greater benefit, than nearly any other type of worker in the United States.
Before we start, the following disclaimer is important because reading the next paragraph could mean the difference between taking action that is very beneficial and making a huge mistake. Read this next paragraph multiple times!
No one at The Numbers Edge is a tax specialist. We do not stay up on the latest nuances of the tax law from year to year, so it is certainly possible that our advice could become outdated and irrelevant without our knowledge. We speak about tax strategy in general for situations that might apply to a lot of people, but may not apply to you specifically. There are many factors that might cause a tax strategy that works for one person not to work for another, such as whether your business runs at a profit vs. a loss; if you itemize deductions vs. take the standard deduction; if you have a lot of dependents vs. none; if you have a high income earning spouse vs. not; what state you’re in, etc. Always talk to an expert in taxes who understands your situation and tax law and can provide advice. Everything related to taxes discussed in this book, on The Numbers Edge website, or by our team is intended to help you ask your tax expert good questions. We don’t and can’t provide definitive answers. If you need a referral to a tax expert, just ask.
Now, on to how this works.
When an employee elects to contribute to a 401(k), that equivalent amount of income is not taxed. So if an employee earns income of $100,000/year and elects to contribute $15,000 that year to their 401(k), taxes due are based on income of $85,000, not $100,000. In 2020, each American is allowed to contribute a maximum of $19,500 to their 401(k), plus another $6,500 in “catch-up contributions" for anyone over the age of 50. This is referred to as the “employee contribution.” (Side note: there are times when a highly compensated employee at a business other employees are limited to a lower amount than this, but we’re not going to get into that here).
Employers (businesses) can also choose to make a contribution to the 401(k) of their employees, above each employee's contribution. This is referred to as the “employer contribution.” This is a payroll expense to the business (reduces taxable income) but does not increase taxable income of the recipient employee.
A one-person business can make both an employee contribution and an employer contribution. There is a specific type of 401(k) program available to businesses where the owner is the only employee (this also works if a husband and wife are the only two employees in the business), known as a Solo 401(k), or an Individual 401(k).
To go straight to the source, here is the IRS guidance on this:
To summarize, for most situations with a Solo 401(k), the business (“employer”) is allowed to contribute towards the employee’s 401(k) plan up to 25% of the employee’s calculated compensation. The calculation of compensation can be different based on the legal entity type (talk to a tax expert!). If the business is a corporation, compensation would be the amount reported on the W2 of the owner/employee, not the total income earned by the business.
Here’s an illustration. Julie, a freelance service provider earns $100,000 a year in net income. Julie's lifestyle is such that she does not need all $100,000 a year to live on, so there are some extra funds available for wealth building.
Julie’s business is an S-Corp for tax purposes. (Side note: many businesses that are not initially set up as an S-Corp can file paperwork with the IRS to be taxed like an S-Corp anyway). Julie sets up a Solo 401(k), and she contributes the employee maximum of $19,500 to her 401(k) plan in 2020. Now, instead of paying taxes on $100,000, her taxes will be based on ($100,000 - $19,500 = ) $80,500. If Julie lives in a high state tax state like California, contributing the $19,500 has reduced the amount of taxes she would have paid by at least $5,000, which is like getting a nice match from the government!
Then, Julie works with her tax expert to agree that she’s going to report $45,000 of the income on her W2, and she’ll report the rest of the business income she wants to receive personally as a distribution. Therefore, she can make an employer contribution to her 401(k) of up to ($45,000 x 25% = ) $11,250 to her 401(k) as the “employer contribution.”
That $11,250 counts as expense to the business, so the reported taxable income from her business will now be ($80,500 - $11,250 = ) $69,250.
Julie has now reduced the $100,000 income earned in the business to $69,250 in taxable income and has contributed $30,750 to her 401(k) this year.
If Julie kept up on this for a decade, she has been able to contribute over $100,000 over that 10-year period more than the maximum allowed to most Americans, and has been able to report $300,000 lower in taxable income than if she was not contributing to the 401(k) at all - huge win!
Of course, the key to this success is that Julie needs to live in a way where she can afford to save and invest that money rather than using it to support her lifestyle.
To members of The Numbers Edge online, I'll let you know where and how I recommend setting up a Solo 401(k), and if you ask I'll send you the paperwork I used in the past so you can simply copy it for your company!
As a reminder, you are strongly encouraged to talk with a tax expert to make sure the benefits of this apply to your particular situation. 401(k) employee contribution limits are per person, not per plan, so if your business is your side gig and your primary employer already has a 401(k) plan, you can only contribute $19,500 to them in combination, not each.
If you have a business with multiple employees, there are still tax-advantaged ways to build wealth through employer 401(k) contributions - it just gets more complicated and a little more expensive because the IRS requires the employer to also contribute to the 401(k) of all employees, not just the business owner’s plan. A business with just a few employees that wants to maximize the wealth of the business owner might consider a SEP IRA. There is a lot of free information available online about SEP vs Solo 401(k) plans, and all tax experts are well versed in strategies these.
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