Each year as the tax deadline approaches, the self-employed that have a Solo 401(k) plan have a powerful tool to lower last year’s taxes and put away a meaningful amount for retirement too.
As long as your Solo 401(k) was setup before December 31st, you may make contributions as an “employer” for the previous year until the IRS tax deadline. In 2022, you can put up to $61,000 into a Solo 401(k) depending on your earnings (it’s $66,000 in 2023).
Your business entity type will determine when your tax deadline is. Entities formed as S-Corps or Partnerships typically have a March 15th deadline, and all other entity types like LLCs and sole proprietors will have April 15th deadline. However, in 2022, the deadline for individuals is April 18th, so sole proprietors may have a little more time. Please verify your contribution and tax deadline with your tax advisor.
How Are the Employer vs. Employee Contribution Deadlines and Limits Different with a Solo 401(k)?
Remember that with a Solo 401(k), you can contribute to your 401(k) in two different ways — both as an employee and as an employer. As an employee you could have contributed up to $20,500 in 2022 (limits increased for 2023) and another $6,500 as a catch-up contribution if you are 50+ years of age. Know that the “employee” deadline for contributions is December 31, while the “employer” deadline is your tax deadline.
As mentioned earlier, the all-in amount you may put into a Solo 401(k) is $61,000 for 2022. That can be made by a combination of employee plus employer contributions or 100% employer contributions.
How to Determine the Amount You Can Contribute as an Employer?
Since you’re both an employer and employee when it comes to your Solo 401(k) plan, the smart moves are to contribute a preset monthly amount as an “employee” that fit your budget during the calendar year, and then after year-end, review your situation and make a one-time, employer contribution that best balances your tax saving needs with your retirement savings goals before the filing deadline.
If your business is structured as a corporation, you can make employer contributions up to 25% of W-2 earnings into the 401(k) plan. If you’re a sole proprietor or own an LLC (or partnership), this percentage may be around 20% based on your net schedule C. The IRS has a publication and worksheet that's fairly simple to follow. Just keep in mind that total contributions as an employer and employee cannot exceed a combined total of $61,000 for the 2022 tax year ($67,500 if you’re over 50 years of age and you maxed your employee “catch-up” contribution).
An Example of How to Lower Your Taxes by $7,920 or More with Solo 401(k) Contributions
The amount you can tax defer will vary by your earnings and your tax rate. Here’s a hypothetical example of how an owner who makes employer contributions of $36,000 will lower taxes by $7,920 assuming an effective tax rate of 22%, versus a person that doesn’t contribute:
Example Solo 401(k) Saving and Tax Calculation & Comparison
| With a 401(k) Contribution | Without a 401(k) Contribution | |
|---|---|---|
| Earnings | $180,000 | $180,000 |
| 20% of Net Self-Employment Contribution | $36,000 | $0 |
| Taxable Income | $144,000 | $180,000 |
| Taxes Owed (22% Effective Tax Rate) | $31,680 | $39,600 |
Again, the owner that contributed to their Solo 401(k) paid $7,920 less in taxes this year while saving $36,000 towards retirement. In actuality, the tax savings could be even greater as the 401(k) contribution may also drop the owner a tax bracket and/or lower the effective tax rate. Remember, this is an example and not meant as tax advice. When 401(k) monies are withdrawn in retirement, it will be taxed with the exception of any “employee” Roth 401(k) savings. Be sure to consult a tax advisor to discuss your specific situation. Be well.
This blog was updated in December of 2022 with 2022 and 2023 contribution limits.