Solo 401k funding, payroll tax tradeoff of single member LLC

4 Replies

Looking for some second opinions on anyone who is "self employed" and has a Solo 401k. Probably folks here know about check book 401k's and such to invest in real estate. 

I am now in a contract position as 1099 and have the option to fund my own Solo 401k up to 55k, which is amazingly awesome compared to most employers just providing the individual limit. 

The gotchya is that they limit employer funding to 25% of the income, which means, to meet the 55k limit you have to exceed the FICA income limit (go figure) and pay maximum payroll taxes. 

I did a spreadsheet calculation of the difference between paying myself 80k (and funding 25% to 401k to make 100k income) (the low end of a reasonable salary for my job) and the salary to achieve maximum funding of 55k (146k). So assuming the business is making net at least 146k, how much is the difference when you adjust the salary across income tax to owner distribution at the 21% rate. 

The result is below. It shows I gain $16,500 in my 401k at the cost of $8569 to the tax man. I really don't think this is that bad. It means I get almost twice the amount of tax protected money per tax dollar handed over. (My Tax state is Arizona).

Then I assumed a return on investment of 12%. So for each dollar saved in taxes by not increasing salary, I assumed earned 12% starting year 1, reinvesting each year those earnings, and the same on the 401k money. 

The result there is that the 401k additional funds can become $120k value in 5 year at 12% return, just interest is 37.5k. The cash saved by not contributing to 401k can only become 62k (and that is without the capital gains taxes considered).  

So by paying the full amount to fund the 401k you end up with extra 18k of interest that is tax free in your retirement account compared to having the cash. Even at 5% ROI, it still appears better.

What do you guys think? 

ROI Expected 12%
401k delta $ 16,500
Income Forfeited $ 8,569 Income Int (Cash) Delta (401k - Cash) Per Year
5 yr interest $ 37,459 (401k) $ 19,454 $ 18,006 $ 3,601
5 yr value $ 119,959 (401k) $ 62,299 $ 57,661 $ 11,532 

ROI Expected 5%
401k delta $ 16,500
Income Forfeited $ 8,569 Income Int Delta Per Year
5 yr interest $ 13,591 $ 7,058 $ 6,533 $ 1,307
5 yr value $ 96,091 $ 49,903 $ 46,188 $ 9,238 

@Leland Smith

This is a great post, and a fine example of exactly why tax-deferred retirement plans are such great wealth-building tools.

You look young.  Have you considered making the employee deferral portion of the contributions to a Solo 401(k) on a Roth basis?  This will diminish the short term benefit as you would pay full taxes now on that contribution, but 12% growth compounded over 25-30 years would be a really huge pile of tax-free money from which to take distributions in your retirement years.

Did you consider:

1) The taxes paid when you eventually withdraw from the 401k?  When you take 401k withdrawals it will all be taxed as ordinary income.

2) The fact that many real estate investments come with tax advantages when invested outside of the 401k.

@Brian Eastman - That is a good idea to model the Roth option as well. I will do that. Because it would be nice to access earnings before 60 if I want to, especially since I have control over my salary now can keep my payroll taxes from being unnecessarily high. BTW I can already fund a Roth IRA as well on top of any 401k contributions and then transfer that money to another account. Since it's after tax, it doesn't matter that it's not tax deductible at my salary. This is another good option if I intend to utilize my 401k plan for investment. Now employer contributions are not able to be contributed after tax... so those would have to be rolled into a Roth IRA account some time later which makes things a bit murkey. The problem with having both Roth and pre-tax is having to keep them separate so you can't combine the cash for greater investment potential.

@Dan Rudolph - I did mention I haven't modeled that, but considering the money greater in the 401k, I think that is all that matters because the same tax assumptions would be present for money earned inside or outside the 401k. The difference with the 401k is that I have the option to withdrawal as much as I choose instead of  being stuck with capital gains on whatever earnings I make in the year. 

@Leland Smith

Since you mentioned a Roth IRA in your comments, just keep in mind that Roth IRAs cannot be transferred to other retirement account types such as the Solo 401k. If you are able to make Roth contributions to a Solo 401k rather than a Roth IRA, you can maintain more flexibility.

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