Rocket Dollar Knowledge Base

Show me the math. How does a Self-Directed Solo 401(k) help me save on taxes?

See the example below.

Let's assume you have a side business as a sole proprietor or you run a business as a single member limited liability company (LLC) moonlighting as a consultant. Taxes are paid by the member of the single member LLC, not the entity itself. The IRS considers the LLC a pass through entity for tax purposes. It's likely you need to fill out an IRS Schedule C to report the money you made or lost in your business. This form, title "Profit or Loss From Business (Sole Proprietorship)," must be completed and included with your income tax return.

So, let's say the business earned $100,000 after deducting Schedule C (or C-EZ) expenses such as travel, entertainment, advertising, software vendors, and salary as compensation. (For self-employed individuals compensation means earned income.) The operating profit is $100,000.

First, we calculate 1/2 of the self-employment tax. The self-employed person's FICA tax rate for 2018 (January 1 through December 31, 2018) is 15.3% on the first $128,400 of net income, so your net self-employment earnings are $92,350 ($100,000 - $7,650).

You can contribute 20% of your net self-employment earnings, so $18,470. Your profit after the employer contribution (or profit sharing contribution) is $63,030 (This article assumes you're operating as a single member LLC. Note profit sharing contributions are limited to 25% of your compensation from an S-corp, C-corp, partnership, or multi member LLC).

Now we subtract the self-employment tax of 15.3%, which comes to $9,644. Your net profit is now $53,386.

With the employee salary deferral in the Self-Directed Solo 401(k) you could contribute $18,500. You've now contributed $36,970 to your Self-Directed Solo 401(k) in total and your taxable income is now $34,886.

With the standard deduction or $12,000 for individuals in 2018 your taxable income is actually $22,886.

You can defer an extra $6,000 if you are above age 50 in a catch up contribution.