No tax if all my business income goes to 401K?

[Cloverissweet]

I plan to quit my job to stay home when I have kids. However I don’t like putting off my retirement saving while doing so. I plan to start my own business, making just enought to max out my 401K contribute.

If I make just enough to max out my 40K contribution, does that mean I have no income tax?

For example, if my business earns 18K a year and I contribute 17.5K to my 401K, the rest probably goes to social security or whatever. Then my AGI is almost zero. Therefore I will not have any tax?

I am not sure if I am understand this self employ 401K probably.

 

[Animorph]

Yes, with a Solo/Individual 401k you can contribute nearly everything you make (even a bit more than the standard contribution limit when "profit sharing" is included). The only thing you'll have to pay is the self-employed SS/Medicare taxes (employer and employee). However you get to deduct half of that from your income, and can contribute all but half the SE tax to your 401k. You can also have a Roth 401k if that makes sense for you taxwise.

 

[pb4uski]

While I haven't crunched the numbers, I suspect that there will be a certain income level where after considering your business expenses, SS, max solo 401k, etc. your incremental taxable income would be nil. You could take a copy of your 2012 return and eliminate your wages and add a Schedule C for your business and get a sense of where it is.

Or you could talk with your tax preparer/advisor.

 

[someguy]

solo 401(k)

You will most likely want to set up an LLC and get a solo (aka individual) 401(k) under the LLC. I have done this through Vanguard and it is pretty simple and they don't charge any direct fees. There are a few negative things to know, though. First, you can't add VG Admiral funds to your solo 401(k) options, so you'll have to pay somewhat higher fees (although still pretty low) for the non-admiral version of funds. Second, if the total funds in the plan exceed $250K, there is additional paperwork the IRS requires. Also, you must have no employees. On the positive side, besides the obvious standard 401(k) type stuff, you can add a Roth 401(k), to which you contribute post-tax money. Also, you can easily do profit sharing contributions (the LLC makes on behalf of you), typically up to 20% of net income of the LLC. If you have the net income, you can contribute up to around $45k/year pre-tax.

With this set up, if your spouse contributes substantially to the LLC, he/she can also contribute $17.5K/year to the solo 401(k), and also receive profit sharing contributions.

So yes, you should be able to make say $17K/year, contribute it all to a solo 401(k), and pay very little to no income tax on that 17K income. You'd do well to pay an accountant a couple hundred dollars to run through the exact specifics of your scenario.

 

[photoguy]

If you are making just enough to fund the 401k, wouldn't you be better off not contributing to a plan and investing the difference in taxable accounts?

 

[someguy]

I realize that, not having enough info, I made a potentially gross assumption. My assumption was that the OP has a source of significant other income (e.g., via a partner, residual commissions, etc). If the new business income would be the only (potentially taxable) income, then as photoguy said, a better option would almost surely be to max a Roth IRA, then to something else taxable, instead of a 401(k). Because at ~17K HHI with dependent(s), I can't imagine there will be any state or fed income tax.

If you are making just enough to fund the 401k, wouldn't you be better off not contributing to a plan and investing the difference in taxable accounts?

 

[brewer12345]

This is exactly what DW has done with her business since inception. You can actually shelter 23 to 24k because the max contribution is 17k plus 25% of net earnings.

 

[samclem]

You will most likely want to set up an LLC and get a solo (aka individual) 401(k) under the LLC.

Why set up an LLC? It's not needed to establish a Solo 401(K) and it adds another level of complexity. IIRC there might have been some advantage in being able to put away a little more in the Profit Sharing component of the Solo 401K, but there were negative attributes as well. Hardly seems worth it at this level of income.

I've got a solo 401(k) with Fido and it has worked out really well. No LLC (though I'd consider it if it made sense for other reasons--liability, etc).

Just take a look down the road and remember that all that money has to come out eventually (probably under the RMD rules) and that under the now-"permanent" tax rates having money in taxable accounts can be a good deal. As a general rule, plunk money into that 401(k) if needed to drop your present marginal tax rate below the rate you expect in retirement, but think hard before going lower.

 

[brewer12345]

Why set up an LLC? It's not needed to establish a Solo 401(K) and it adds another level of complexity. IIRC there might have been some advantage in being able to put away a little more in the Profit Sharing component of the Solo 401K, but there were negative attributes as well. Hardly seems worth it at this level of income.

I've got a solo 401(k) with Fido and it has worked out really well. No LLC (though I'd consider it if it made sense for other reasons--liability, etc).

Just take a look down the road and remember that all that money has to come out eventually (probably under the RMD rules) and that under the now-"permanent" tax rates having money in taxable accounts can be a good deal. As a general rule, plunk money into that 401(k) if needed to drop your present marginal tax rate below the rate you expect in retirement, but think hard before going lower.

An LLC is only a consideration as a means of protection from liability I would think.

As far as the choice of solo 401k vs taxable account, it depends on your tax situation. DW utilizes a solo 401k because every dime she earns is at our marginal rate. If I were not bringing in any money, we would just put the money in a taxable account. I believe OP hase a working spouse, so a solo 401k is probably a good idea.

 

[samclem]

If I were not bringing in any money, we would just put the money in a taxable account. I believe OP hase a working spouse, so a solo 401k is probably a good idea.

One nice thing about the Solo 401K is that, like an IRA, the contribution period is after the end of the calendar year. This makes it a good tool for fine-tuning taxable income after Dec 31st and after all the dust has settled from other income sources.

 

[ziggy29]

I've got a solo 401(k) with Fido and it has worked out really well. No LLC (though I'd consider it if it made sense for other reasons--liability, etc).

An LLC is certainly a more bulletproof asset protection mechanism, but a 401K can be pretty good if you live in a state where 401K assets enjoy high levels of protection from lawsuits. In a few states, 401Ks can be protected to an unlimited amount of money.

And while that asset protection wouldn't protect you in case of criminal activity, gross negligence or fraudulent conveyance, neither would the LLC.

 

[brewer12345]

One nice thing about the Solo 401K is that, like an IRA, the contribution period is after the end of the calendar year. This makes it a good tool for fine-tuning taxable income after Dec 31st and after all the dust has settled from other income sources.

Yup. It is very helpful that way.

I forgot to mention earlier when someone mentioned the requirement to have to file annual paperwork when the account value tops $250k:

If DW's 401k approaches that level, I plan to avoid the paperwork requirement. Simply dissolve the plan, transfer the assets to an IRA, and form a new plan with a zero balance. Voila, no filing requirement.

 

[samclem]

If DW's 401k approaches that level, I plan to avoid the paperwork requirement. Simply dissolve the plan, transfer the assets to an IRA, and form a new plan with a zero balance. Voila, no filing requirement.

I'd considered this, but one thing stopped me: The Solo401k can be tapped without penalty starting at 55 if the employee terminates the plan/is let go (by himself?) , etc. in that year. There's more on age 55 and the Solo 401K here.

IRA's can't be tapped (excepting 72T withdrawals) without penalty prior to 59 1/2. It might not make any difference in your case, but we may be a bit short in taxable account $$ while we wait to hit 59.5. So, I'm pretty sure my boss (me) is going to fire lazy old me when I hit 55, and then I'll get penalty-free access to the Solo 401K money a few years earlier. In our case that might be useful.

 

[DayDreaming]

I'm retired from my old day job, but make a small income from a part time hobby/business. At first, I was putting some of that income into my IRA. But now I'm thinking I have too much tax sheltered $$$ in IRAs and the RMDs will give me too much income when that time comes around, putting me into a higher tax bracket. So, instead of contributing more to the IRA, it makes more sense for me to pay taxes on it now since I'm in a very low tax bracket. Something you may want to consider it applies to you.

 

[samclem]

So, instead of contributing more to the IRA, it makes more sense for me to pay taxes on it now since I'm in a very low tax bracket. Something you may want to consider it applies to you.

Yes, it's a balancing act. We contribute enough to the IRAs and 401Ks to get our taxable income into the same bracket we'll be in during retirement (we think). In the gap between when I quit w*rking and when we can gain access (without penalty) to the IRA/401K money, we'll have three other ways to get money from the portfolio:
-- Take 72(T) withdrawals from the IRA
-- Withdraw money from the taxable account
-- Withdraw our contributions from Roth IRAs.

And that's probably the order we'll use each year.

Oh, and one clarification to an earlier comment I made: The employee contribution to a solo 401K (approx $17K plus any "catchup" contribution allowed) can be made after 31 Dec. The employer part of the contribution has to occur before Dec 31. (in general. Maybe there's a provision for businesses that use a different year accounting year, etc). See a real accountant for real information.

 

[pb4uski]

I'd considered this, but one thing stopped me: The Solo401k can be tapped without penalty starting at 55 if the employee terminates the plan/is let go (by himself?) , etc. in that year. There's more on age 55 and the Solo 401K here.

IRA's can't be tapped (excepting 72T withdrawals) without penalty prior to 59 1/2. It might not make any difference in your case, but we may be a bit short in taxable account $$ while we wait to hit 59.5. So, I'm pretty sure my boss (me) is going to fire lazy old me when I hit 55, and then I'll get penalty-free access to the Solo 401K money a few years earlier. In our case that might be useful.

If that is a constraint could you simply let the business and related 401k go dormant, and start a new business and 401k? Seems too easy, but it might work.

 

[samclem]

If that is a constraint could you simply let the business and related 401k go dormant, and start a new business and 401k? Seems too easy, but it might work.

I'm not sure, but for most folks that would probably be more trouble than just doing what the IRS wants. The reporting requirements once a plan tops $250K are not significant: It's a two page form ( Form 5500-EZ ) and it is very straightforward. It doesn't result in any new taxes. You also need to get an Employer ID Number (EIN) if you haven't gotten one already, but that's done with a simple phone call. So, in this case the workaround probably isn't worth the hassle.

Another hoop: The trick to accessing the solo401K at age 55 is (IIRC) that your employment with that company has to have terminated in that year (not earlier), otherwise you have to wait until 59.5 YO. If, say at age 50, you set up another plan to replace your first one and didn't make any contributions to the first one, it might be harder to explain to the IRS how you were eligible for penalty-free withdrawals from Plan 1 at age 55.

 

[someguy]

My recollection is that employee and employer contributions have to be *elected* in the same year (i.e., on or before 12/31), but that the funding of said elections simply have to take place before the entity holding the 401(k)'s taxes are filed. It seems logical to me that the employer profit sharing portion would naturally take place later, since it may not be known exactly what the net profits are until the tax figuring process has started.

BTW -- several high-level CPA accountants I've worked with or talked to knew less about solo 401(k)s than I did. (Not saying I know a lot, just that these accountants knew essentially nothing).

Oh, and one clarification to an earlier comment I made: The employee contribution to a solo 401K (approx $17K plus any "catchup" contribution allowed) can be made after 31 Dec. The employer part of the contribution has to occur before Dec 31. (in general. Maybe there's a provision for businesses that use a different year accounting year, etc). See a real accountant for real information.

 

[Animorph]

I'm retired from my old day job, but make a small income from a part time hobby/business. At first, I was putting some of that income into my IRA. But now I'm thinking I have too much tax sheltered $$$ in IRAs and the RMDs will give me too much income when that time comes around, putting me into a higher tax bracket. So, instead of contributing more to the IRA, it makes more sense for me to pay taxes on it now since I'm in a very low tax bracket. Something you may want to consider it applies to you.

Perfect situation for converting a portion of your IRA into a Roth IRA! Reduce your RMD's and no future income tax on the Roth gains. Convert just enough to keep your marginal tax return the same as it is now.

 

[eridanus]

My recollection is that employee and employer contributions have to be *elected* in the same year (i.e., on or before 12/31), but that the funding of said elections simply have to take place before the entity holding the 401(k)'s taxes are filed. It seems logical to me that the employer profit sharing portion would naturally take place later, since it may not be known exactly what the net profits are until the tax figuring process has started.

Yeah, I thought it was the opposite too. The employEE has to be pre-12/31 but the employER has until tax filing time.

Also, I read earlier -- the 25% contribution rate is if you're incorporated. It's 20% if you're 1099/LLC.

 

[pb4uski]

....BTW -- several high-level CPA accountants I've worked with or talked to knew less about solo 401(k)s than I did. (Not saying I know a lot, just that these accountants knew essentially nothing).

Not surprising unless they specialized in personal income taxes or small business income taxes. I worked in corporate accounting and this wouldn't be on the radar at all.