The Fix: Solo 401(k)s Provide Big Opportunities for High Earners

THE SITUATION

The business owner, a realtor, has no employees but may have a spouse assisting in the business (also common with health insurance agents, consultants and others) and isan LLC filing as an S-corp. They’re already saving for retirement through contributions to SEP IRA.

• Current W-2 wage: $90,000

• Spouse is admin assistant but no wages paid

• Husband and wife are both over 50

• Expected S-corp distribution $390,000

The Client’s Burning Question: “Is the Solo 401(k) with Profit Sharing worth consideration?”

PLANNING

Ultimately, the goal from our planning perspective is to use all the tools available to us to help our clients. Should they be considering a Solo 401(k)? We looked at a few critical facts:

• How much could they be contributing pretax? With the current rules, pretax contribution in this scenario through the 401(k) and profit sharing is $53,000 with no need to raise W-2 wage.

• The business decided to add a wage for the spouse to gain additional benefits. For example, if the spouse earned a $23,000 wage, this would allow approximately $23,000 to be contributed pretax to the spouse. Yes, payroll taxes would offset some tax savings, but overall, this strategy could make sense at this marginal tax rate for the couple.

• What are the costs for a Solo 401(k) plan? Solo 401(k) fees vary, but on average we’ve seen costs for plan documents at around $350 and then $100-$250 a year to maintain.

In addition, a Solo 401(k) may present additional opportunities for sheltering down the road. For example, if a client has IRAs that prevent nondeductible contributions and subsequent conversion to Roth IRAs (like the SEP IRA this client was using) those funds are stuck. But if they switch to a Solo 401(k) they will be able to transfer IRAs to a 401(k) and, because he has no other Traditional IRA accounts, make contributions in nondeductible IRA on top of the 401(k). They could then do a “backdoor” Roth IRA for he and his wife allowing for an additional $6,500 each, or $13,000 total, to be contributed through nondeductible IRAs and converted to Roth IRAs.

IMPACT

Potential tax benefits for the client in pretax contributions are big. In fact, by implementing a Solo 401(k), they grew from $22,500 to $76,000 — an additional $53,500. Just doing the rough math on an expected 42% tax rate on this income, that’s more than $22,000 in additional tax savings. The only expenses? Payroll tax increases of $3,500 and admin costs of $350. Not bad.

Editor’s note: This scenario in principle actually occurred to a THG client. The facts, names, and dollar amounts of this situation have been changed to assure anonymity. This is not a client testimonial and does not represent an actual client’s facts.

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