Can A Solo 401(k) Reduce Your Taxable Income?

People often spread misinformation, either intentionally to make themselves look good or by accident. Maybe they got their information from a bad source, or maybe they forgot some of the details when passing it along. If you’ve ever played a game of telephone, you know how wacky things can get. So, when people say a Solo 401(k) plan can reduce your taxable income, is it really true?

Author

Josh Cruz

May 4, 2023

People often spread misinformation, either intentionally to make themselves look good or by accident. Maybe they got their information from a bad source, or maybe they forgot some of the details when passing it along. If you’ve ever played a game of telephone, you know how wacky things can get. So, when people say a Solo 401(k) plan can reduce your taxable income, is it really true?

Retirement plan contributions including a Solo 401(k) is tax-deferred, which means instead of being taxed in the year the income is earned, taxation is deferred on contributions made to the plan. This in turn reduces taxable income. However, a Roth contribution to a Solo 401(k) does not receive the same tax reduction for the contribution but instead  the earnings may eventually be distributed tax-free.

So, like many things in this world, the answer is essentially it depends on which one you get. There’s a lot that goes into these plans though, so keep reading for more information and answers to some common questions regarding the taxation of Solo 401(k) retirement plans.

What is a Tax-Deferred 401(k)?

A tax-deferred 401(k) plan is a retirement plan that does not pay taxes when the money is contributed. Money is taken out of paychecks or net income before taxes are paid on it. Taxes are then deferred not only on the contributions but also the earnings on investments made from those contributions until money is withdrawn. This lowers taxable income now, but will eventually need to be paid down the line.

There are a few types of tax-deferred 401(k) plans which are:

  • Regular 401(k) for employers with rank-and-file employees

  • SIMPLE 401(k)

  • Safe Harbor 401(k)

  • Solo 401(k) - employers with no rank-and-file employees 

It is important to note that there are two kinds of employee contributions that can be made  to a Solo 401(k) plan: one is a pre-tax deferral tax-deferred plan and one is a designated Roth Solo deferral).

When Do You Pay Taxes on a Solo 401(k)?

Generally, you pay taxes on your Solo 401(k) funds you withdraw.  Taxation occurs on pre-tax accounts since taxation is tax-deferred. Roth earnings may also be taxable if certain criteria have not been met.  

However, if the Roth Qualified Distribution criteria are met (5 years and death, disability or attainment of age 59 ½), Roth account earnings are distributed tax-free.  It’s also important to note that starting at age 73, the IRS requires distributions from the plan from both pre-tax accounts and the designated Roth account under the plan.  

This is called a Required Minimum Distribution (RMD). Starting in 2024, Designated Roth accounts are exempt from RMDs. So, if you have yet to retire at this age, you will need to start taking money out of the plan which will in turn be taxed depending on the account as the IRS considers that taxable income.  

Do You Pay Taxes on Interest in a Solo 401(k)?

Regardless of which kind of Solo 401(k) you are enrolled in—a traditional tax-deferred plan or a Roth—money inside grows tax-deferred, meaning earnings are not taxed as it remains under the plan.. Money stored within a pre-tax Solo 401(k) is not subject to taxes until it is withdrawn. 

So, with one of these plans, however much money is withdrawn is subject to taxes as the IRS considers it taxable income. It is always good to seek the assistance of your tax advisor before taking a distribution to determine the tax implications.

With a designated Roth account, taxes are paid upfront when it is contributed to. Then everything inside grows tax-deferred as well but later when the Qualified Distribution criteria are met will be tax-free. That means that while there are more taxes paid up front, there won’t be any down the line forever. That includes the interest!

Do You Pay Taxes on Solo 401(k) Investments?

Just like with the interest not accruing taxes, any investments made with a Solo 401(k) plan do not accrue taxes. Of course if you buy property, those taxes still apply. What you do not pay taxes on are  any money that is earned through investments while it is within the plan. All money grows within a Solo 401(k) without taxation regardless of which kind of plan it is.

If that plan has a designated Roth account, it is entirely tax-free even when withdrawn despite the fact that the interest and investments will have made more money than what was put into the plan. With a  pre-tax account, it will be taxed when withdrawn as taxable income.

What Kind of Investments can be Made with a Solo 401(k) Plan?

For the most part, it depends on the provider. There are many traditional assets and nonconventional ones to choose from; more so than with a regular employer-based 401(k) plan. Some providers will have dedicated packages and portfolios for their clients to select from, while others are much more self-directed. Self-directed means the participant gets to choose their own investments.  

So in a self-directed plan, although it may allow for investments such as real estate, notes, mortgages, precious metals and others, the participant’s own due diligence is required. In some cases the help of a tax, legal or investment professional may be helpful.

Traditional Assets You Can Invest in

Almost every provider will have these sorts of assets available for their clients to invest in.

  • Annuities

  • Bonds

  • CDs

  • EFTs

  • Money Market

  • Stocks

Although these are common investments offered by financial institutions, there is no guarantee on the returns. It is important to involve your tax legal or investment professional before making any decision. 

Unconventional Assets You Can Invest in

There are a lot of assets considered unconventional that can be invested in using a Solo 401(k) plan, even if they are more popular than others. Self-directed providers do not offer any investments.  Instead they offer a platform that allows for the investor to choose, manage and invest to their liking.

Here are a few of the possible unconventional assets available to be invested in with a Solo 401(k) plan:

  • Real Estate (both residential and commercial)

  • Various Loans and Financing

  • Leasing and Rentals

  • Business

  • Blockchain

  • Cryptocurrency

  • Foreign Currency

  • Life Insurance

  • Precious Metals

  • Energy

  • Movie and Theatre productions

Do note however that with more unconventional assets, some of these the IRS will still consider to be taxable even if they are within a Solo 401(k).

What’s the Difference Between a Tax-Deferred and a Roth Solo 401(k)?

With a traditional, tax-deferred Solo 401(k), taxes are not paid until the funds are withdrawn. That also usually allows for contributions to be considered deductible expenses. These are also the plans that the IRS usually requires distributions from starting at age 73.

With a Roth Solo 401(k), taxes are paid at the time of contribution, with everything growing inside tax-deferred. If the participant satisfies the Qualified Distribution criteria, all of the accounts including earnings are tax-free for the rest of the individual’s lifetime. 

Neither of these plans are necessarily better or worse than one another for every single person interested in a Solo 401(k) retirement plan. You’re also not locked into one or the other for your entire life and can swap as necessary with the help of a qualified provider. You are also allowed to have both types of contributions under the same plan!

What are the Contribution Limits for a Solo 401(k)?

With a Solo 401(k), the contribution limits are higher than other types of retirement plansContributions can be made as both the employee and the employer. Up to 100% of your net income can be contributed to the plan.

The exact numbers are based on your income. Multiple websites will try to offer specific numbers, but those numbers are likely generalized based on a traditional 401(k) plan made through an employer, rather than an actual Solo 401(k) plan. There are also various factors that can adjust your personal contribution limits. Oftentimes, unless you make an outrageous amount of money from your business, you will never actually reach the contribution limits a Solo 401(k) allows just from the income from that business.

It is important to note, as stated a few times thus far, after the age of 50, the limits increase further; these contributions are called catch-up contributions. However, once you reach the age of 73, the IRS requires distributions from the plan. 

The exception to the RMDs is starting 2024 Roth type contributions to a 401(k) will no longer be included as part of the calculations. Checking with an expert such as those at SEPira(k) can help you find your exact contribution limits. It can be complicated and hard to understand without them. But, having that personalized assistance can really make it easy to follow and to make the most of it.

Does a Solo 401(k) Reduce Self-Employment Tax?

If you make $400 or more in a calendar year through a self-employment venture, you are subject to self-employment tax. Contributing to a Solo 401(k) does not reduce your self-employment tax. Anything under $400 is considered a hobby that just happens to bring in money and does not need to be filed.

That means regardless of having a Solo 401(k) taking contributions or not, you will still need to pay self-employment tax based on how much you earned within that calendar year.

Will Your Taxes be Less in a Solo 401(k)?

Contributing to a Solo 401(k) does not reduce the tax that you will owe on the money you put into the plan. With a pre-tax account under a Solo 401(k) plan, distributions are taxed as regular income.  So consult with your tax advisor. On the other hand, Roth accounts have taxes paid up front, with potentially everything then growing tax free which will lessen taxes in the long run. Many times this is the preferable route to take.,  But iIt really depends on what needs and goals the individual has.

Who is Eligible for a Solo 401(k)?

There are only a few eligibility requirements for a Solo 401(k), and thankfully, unlike much of the other things the IRS handles, are rather straightforward.

The requirements are:

  • You must be self-employed or have a business whose intention is to generate profits

  • You cannot have full-time rank-and-file employees; a spouse and partners are an exception

  • You must be a United States resident

  • You need to be at least 21 years of age

Additionally, contributions to a plan have to be recurring and substantial. Additionally, if there are certain factors such as employees working 1,000 hours annually for three consecutive years, they may have an impact on the plan. Remember however that these requirements can be waived for employees who are employed as of plan inception.

Who Can I Contact to Get Assistance with a Solo 401(k)?

There are many Solo 401(k) providers out there to choose from to suit your needs and help get you started or even rollover an existing 401(k) plan into a Solo 401(k). Do note that the current best practice is a bunch of Excel spreadsheets which the provider will require their client to maintain more or less by themselves.

This is why SEPira(k) is highly recommended. They have a state-of-the-art platform that helps to make managing and recordkeeping for a Solo 401(k) plan an absolute breeze. It’s extremely secure and has a robust backup system to help keep your money safe.

The IRS can disqualify any plan for any small misstep called an “operational failure”, so having a platform like SEPira(k) will mitigate that risk.  Having this type of platform that  can manage the recordkeeping for the client instead of the client basically balancing a checkbook while the IRS is breathing down their necks is a lifesaver. The platform makes sure everything is in order, making it all infinitely less stressful while still allowing for self-direction from their clients.

They also have a wide range of investment opportunities that can be made within the Solo 401(k) plan that clients are welcome to hold under their plan.

These investments include:

  • Real Estate (both residential and commercial)

  • Tax Liens

  • Private Placements

  • Precious Metals

  • Energy

  • Equipment Leasing

  • Foreign Currency

  • Stocks

  • Bonds

  • Mutual Funds

  • Cryptocurrency

Plus, if there’s something else that seems to be of interest, you can always chat with their experts to see if it is a viable option for investing with your Solo 401(k) plan.

While saving for retirement can be stressful because of everything needing to be absolutely perfect and having so many customized variables, SEPira(k) makes it much less so. That opens up more room for their clients to get to what really matters—the rest of their lives.

Conclusion

There are two different kinds of contributions that can be made in a Solo 401(k) plan.. One is a traditional, or pre-tax contribution  in which taxes are not paid on the money within until it is withdrawn. Then it is considered taxable income. This in turn reduces the taxable income now, and essentially pushes it off until later.

The other type is a Roth type of contribution. With these kinds of contributions,  taxes are paid up front and then hopefully never again. So, the taxes are paid now, but non-existent later on. This is often preferable, but not always the best option for everyone. The good news to that is that these plans are not mutually exclusive, nor do they always have to stay the same throughout their entire lifespan. You have options!

Just remember that the IRS can be picky with a lot of things, and a Solo 401(k) is no different. At least they are for the most part straightforward when it comes to them, but any small misstep can be costly. The good news though is that providers such as SEPira(k) are here to help make the process as simple as possible.

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