Tax Strategy for Self-Employment Income, Part 5: Individual 401(k) Analysis & Resources

Contributed by mm | September 1, 2005 12:35 PM PST

Being able to defer more than $40,000 of income via individual 401(k) is certainly an appealing option. Let's run the math and see how specifically our household can benefit from it. We will assume that my wife and I each earn $20,000 via self employment, and we will adopt an individual 401(k) as solo proprietorship. Our analysis in the part 3 of this tax series demonstrates that we should expect to pay $14,091 more on various taxes for the $40,000 incremental income on top of our job income.

The Model:

The tax consequences for the individual 401(k) route should more look like this:

	Me	Wife	Total
Total Self Employment Income - Net Profit	$ 20,000	$ 20,000	$ 40,000
Tax Bracket			28%

Solo Proprietor with Individual 401(k)
	Me	Wife	Total
Schedule C: Net Profit	$ 20,000	$ 20,000	$ 40,000

Schedule SE:
Net Earnings from Self-Employment (92.35%) (*)	$ 18,470	$ 18,470	$ 36,940
Self Employment Tax (**)	$ 536	$ 2,826	$ 3,362
Form 1040: Deduction (1/2 of Self Employment Tax)	$ 268	$ 1,413	$ 1,681

Individual 401(k) Contribution
Assumed Employee Contribution	$ 14,000	$ 14,000	$ 28,000
100% of Net Profit, Up to $14,000
Assumed Employer Contribution
20% of (Net Profit - SE Tax Deduction), Up to $42,000	$ 3,946	$ 3,717	$ 7,664
Total	$ 17,946	$ 17,717	$ 35,664


Form 1040 Impact (as increments to earned income)
Business Income (Line 12)			$ 40,000
Self-Employed SEP, SIMPLE and Qual. Plans (Line 32)			$ (35,664)
Self Employment Tax Deduction (Line 30)			$ (1,681)
Total Taxable Income (Line 42)			$ 2,655
Income Tax (Line 62)			$ 744

Total Tax Effect
Federal Income Tax Paid			$ 744
Self-Employment Tax Paid			$ 3,362
Total Tax Paid			$ 4,105
% of Total Self Employment Income Taxed			10%

Income Deferred (Subject to Future Tax)			$ 35,664

Future Tax Exposure (at Current Tax Rate)			$ 9,986
Total Tax Liability			$ 14,091

(*) After deduction of employer's share of self-employment income.
(**) 2.9% for me because I maxed out social security tax from my job income; 15.3% for my wife.

The result: with this strategy, we should expect to pay only $4,105 upfront (vs. $14,091 without a 401(k) plan). Up to $35,664 of income can be deferred. Still, individual 401(k) plan for solo proprietor does not really reduce tax -- it just delays the tax payment and allows you to enjoy some tax-deferred growth in your 401(k) account.

Notes

• Tax form and line numbers are included for reference.

• If the business is not incorporated, it appears that the employer contribution is not exempt from self-employment tax. That is because the employer contribution will be dependent on the total profit of the business (instead of W-2 income if the business is incorporated). In this case, you have to produce Schedule C first (IRS specifically prohibits you from claiming a deduction in line 19 of Schedule C -- see form instructions), and in turn, all income from Schedule C will be subject to self-employment tax in Schedule SE. (I'll also run a calculation for individual 401(k) for incorporated business later in this series.)

• Also, if the business is not incorporated, the maximum employer contribution you can make to your plan is 20% of your earning (profit from Schedule C minus the deductable part of the self employment tax). This is not discrimination against unincorporated businesses: the effect is the same as if incorporated businesses contributes 25% of employee net pay. Part 5 of IRS Publication 560 explains the various ratios in more details.

How to Set It Up

Although Individual 401(k) was only made available a couple of years ago, many firms are already providing turnkey solutions to self-employed individuals.

For example, Fidelity offers a streamlined package of setting up an individual 401(k) plan based on IRS pre-approved templates. The plan claims no annual fee and minimal paperwork requirement. For our household, it is a definitely viable choice for us now that both wife and I have our corporate 401(k) and other accounts set up at Fidelity.

One deficiency of Fidelity's individual 401(k) plan is its lack of 401(k) loan feature. For people who appreciate the loan feature, 401kBrokers.com provides a low-cost alternative. 0.25% of total assets is all what it charges, for setting up and admiistrating your individual 401(k) program in Vanguard, Ameritrade or other institutions. (By the way, its FAQ section is a must-read for people who want to learn more about individual 401(k) plans.) The quarter-of-a-percentage-point fee does not sound outrageous -- after all, it amounts to only $100 a year for every $40,000 assets in 401(k). I'm more inclined to compare it to the annual fee of my Home Equity Line of Credit. Think of it as a nominal fee to insure your future liquidity.

More Individual 401(k) Resources

• 401(k) Help Center: Everything about what a small business owner should know about individual 401(k).
• Clutter to Cash, another personal finance blog, shared the experience of opening an individual 401(k) account at Fidelity.

Ahead in this series are analysis of other small business retirement plans, and different ways to form a small business to achieve maximal tax efficiency. Read on.

This post is part of the Tax Strategy for Self-Employment Income Series, please also read the rest of the series:

Part 1: The Tax Exposure
Part 2: The Framework
Part 3: The Major Options
Part 4: Individual 401(k) Introduction
Part 5: Individual 401(k) Analysis & Resources
Part 6: SEP IRA and SIMPLE Plans
Part 7: Forms of Doing Business
Part 8: LLC and S Corporation
Part 9: C Corporation
Part 10: The Conclusion