In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. explains how you can lower your taxable income using a Solo 401(k) if you are self-employed or have a small business with no full-time employees.
$60,000+ in Deductions Available for your Small Business
Hey everyone, Adam Bergman here, tax attorney and founder of IRA Financial. On today’s podcast, want to talk about $60,000+ of deductions that could be available for your small business, but you need to act kind of quick. So, Solo 401(k) is today’s focus. Now, you’ve probably heard me over the years talk about Solo 401(k)s for small business owners. I’ve written two books on it; it is the best retirement plan out there for the self-employed or the small business owner with no full-time employees.
So, on today’s podcast, I’m going to talk about eligibility, why you need to set one up, why setting one up before 12/31/22 makes such a major difference, then ultimately why it’s so important from a tax and retirement standpoint, to save through a 401(k) plan.
So, let’s start off at the top. Eligibility. Who can set up a Solo 401(k)? So two requirements. Number one, you need to have a business, right? It could be any business; could be selling shoes on eBay, could be selling necklaces on Etsy, be a lawyer, accountant, consultant. A business is a business, you kind of know it when you see it; not a hobby, right? So, if you selling a couple baseball cards on eBay, probably not a business, right? There needs to be the anticipation of revenue, not necessarily profit, but there needs to be an anticipation that you’re going to make something at least gross, not necessarily net, but gross.
Real estate is the only gray area, right? We know there’s millions of businesses that are passive. Real estate businesses. Like, I have real estate, it’s not my business. I have some rental properties. I file schedule E, as an Edward. I don’t pay Social Security or self-employment tax on that income. But, it’s still passive income, right? Is it a business? No, I’m not treating as a business; treating it as passive. We also know, on the flip side, millions and millions of Americans treat real estate as their business, whether they’re a realtor, a developer, flipper, contractor, whatever it is, they’re involved in the real estate business.
So, how do you turn real estate into an active business if you’re self employed or have a single member LLC? Well, you move it from a schedule E to a schedule C, as in Charlie. Yes, that will subject that net income to self-employment/FICA taxes. But, flip side is deductions will be able to reduce your net income, and whatever that net income is, it is available to be contributed to a 401(k) or an IRA. So the advantage is, hey, you go from E to C. Yes, there’s potentially 15 or so percent of Social Security/FICA taxes on that net income. But you can then take a lot of that income, and we’ll see in a minute exactly how much, and then move it into a 401(k). So, you’re really potentially reducing that net taxable income, putting it into a retirement plan instead of giving it to Uncle Sam, and hopefully benefiting today by way of a deduction and in the future by way of deferral.
The only difference between E and C from a real estate standpoint, passive or active, is the Social Security/FICA, that 15%, right? You still pay tax on your rental real estate. You just aren’t going to pay Social Security and FICA if you’re treating it as a passive activity versus an active business.
So now that’s the first eligibility; you have a business, and as I mentioned, in most cases, super clear, real estate a little bit of gray, but you have the flexibility to kind of go either way. Second, is you can have no full-time employees. Full-time is 1000 hours or three consecutive years of 500 hours that are non-owners and non-spouses of owners. So, you can have owners and their spouses work over 1000 hours, and that still allows you to have a Solo 401(k). So even if you have seven owners and their spouses, so 14 people, as long as you have no non-owner spouses, employees, you can set up a Solo K for those individuals. Now, only people that earn compensation from the business would be eligible to make contributions to the plan, but you can still have a Solo.
What happens if you have employees? Well, just like if you work at Apple or Tesla or IRA Financial, you’re going to need to set up a regular ERISA 401(k), which is still great, but we’ll see in a couple of minutes that you’re not potentially going to be able to put away as much money and may not have as much investment diversification options because the plan is subject to various ERISA fiduciary rules. So those are the two requirements. One, US business. Two, no full-time employees other than owners and spouses. Full-time employee means 1000 hours during the year or three consecutive years of 500 hours or more. So, now we know what the eligibility requirements are,okay? So, hopefully you’re listening or watching this on YouTube and you’re saying, okay, I think I’m in line. I think I potentially can do this thing.
Question two, why should I do it, Adam? Why are you talking $60,000+ in deductions? Why am I listening to this? Well, in 2022, you can put away, if you’re under 50 years old, $61,000; if you’re over 50, $67,500. So, let me break that down for you. So, there’s two components to making 401(k) contributions. One is the employee deferral, and two is the employer profit sharing. So, let’s talk about one. Employee deferral: in 2022, dollar for dollar, you can put away $20,500 if you’re under 50 years old or $27,000 if you’re over 50. So, that means if you made $40,000 and you are able to put away $20,000, you could reduce your $40,000 in taxable income down to $20,000. So, now you only pay tax on $20,000.
And that $20,000 goes into a 401(k) plan, which, number one, gives you that deduction, and number two, that money now is in the 401(k), it can grow without tax. That is known as tax deferral, compounding returns, eight wonder of the world, Albert Einstein; you heard my spiel before. Eight years, assume the average an 8% rate of return, your money should double every eight years, okay? So, you get two monster benefits: deductions upfront, and power of deferral going forward. So that’s the employer deferral: $20,500 or $27,000 if you over 50.
Then, the employer contribution, which is 20% of your of your net schedule C, if you’re a sole proprietor or single member LLC, or 25% of your W-2 up to a maximum when you combine the employee and the employer of $61,000 or $67,500 if you’re over 50. So, we’ll go through some examples, but just remember, the employee deferral could be pretax or Roth. For purposes of today’s podcast, we’re going to talk pretax because why? We want to generate deductions, right? Why are deductions important? You saw my example, or you heard of my example. You earn $40,000, you can get $20,000 deductions. Now you only pay tax on $20,000.
I’m a tax lawyer. I can remember my first tax course back in 1998: Federal Income Taxation I. One of the first, probably one of the first things that came out of the professor’s mouth, was a good tax lawyer does the following: generates deductions, finds ways to generate deductions for their clients, or finds ways to either defer or eliminate tax. If you can do one or two of those things, that’s an accomplishment. You’ve done your job.
So, what are 401K contributions doing? Well, number one, if you are doing pretax, you’re getting a deduction, okay? So, put my tax lawyer hat back on, accomplish my goal. And number two, the money is in a 401(k), not in your pocket, which means it’s going to grow without tax. Why? Because 401(k)s and IRAs are exempt from tax as per Section 501, Section 401, okay? So, that’s why I love this industry. That’s why I got into this industry. It is an ideal fit for a tax lawyer. Again, why? Because you generate lots of deductions, and number two, you take advantage of the power of tax deferral. This is music to a tax attorney’s passion, okay? It’s like classical music teacher being able to go back in time and listen to Mozart or Beethoven. This is it. This is the Super Bowl if you’re an NFL player. Like for me, for any tax lawyer, the retirement system is such an ideal fit because it takes advantage of two of my goals. Number one, get deductions. Number two, defer as much tax as I can and figure out a way to keep pushing it, pushing it forward.
So, when you add the employee deferral and the employer contribution, $61,000 or $67,500 if you’re over 50. Those numbers are going to go up a bit in ’23 to $66,000 if you’re under 50, or $73,500 if you’re over 50. But that’s in ’23. We’re talking ’22 taxable year.
So, why am I doing this podcast today? Well, if you want to take advantage of maximum deductions for ’22, you need to set up a Solo 401(k) in ’22. Why? If you set a Solo K up in ’23, you’re only going to be able to take advantage of employer contributions; that 20 or 25%. You’re not going to be able to get the employee deferral, the $20,500 or the $27,000 if you over 50 for ’22. You can take advantage of more deductions for ’23, but let’s focus on ’22 because we still have, you know, under 30 days left before the end of the year. This is the time to kind of put our thinking caps on and figure out the best way to maximize deductions. You’re going to thank me when it’s April 15 and you got to write a check to Uncle Sam, say, oh my God, thank God, I listened to that podcast or watch that video from that guy Adam with the crazy curly hair because he’s telling me how I could save taxes.
And again, not everyone could put away $20,500 or $27,000 or $50,000, I get it, I get it. But every dollar matters, even if you can put away five K or seven K or ten K, that money is going to reduce your taxes. So, if you made 80 grand and you can get a $10,000 deduction paying tax on $70K, then you maybe have other standard or itemized deductions that could reduce your tax further. With the retirement account, other than charity, the retirement account, especially the Solo K, is probably going to give you the biggest bang for your buck. It’s going to give you the best opportunity to maximize deductions because the amounts are so high,okay? Traditional IRA is $6,000 or $7,000 if you’re over 50. A SEP IRA, which you guys probably heard of, will give you a maximum of $61,000, no catch up if you’re over 50. But, a SEP IRA is just a pure profit sharing plan. So, all you’re going to be able to do is either 20% if you’re a sole proprietor or single member LLC, or 25% if you’re a W-2, C or S corp or partnership.
So, for example, I’ve used this example many times. I’ll use it again. It illustrates the value of the Solo 401(k). You make $100,000; you’re 55 years old. Let’s just say you have an S corp. So, you make $100,000 W-2. You’re watching this video; you’re listening to the podcast and say, oh, this guy seems to know what he’s talking about. He’s a tax lawyer. Okay, let’s, let’s figure this out. So, I’m going to set up a Solo K in ’22. I made $100K. My business did okay. I have some extra cash lying around. Let’s talk about maximizing my deductions. If I did a SEP IRA, I could do $25,000, 25% of $100K. It’s good, nothing wrong with that. Very good. Solo K, I can do $27,000 dollar for dollar, plus $25,000; give me $52,000, double, more than double the SEP IRA. So whoa, $52K or $25K. Even my nine year old kid knows which wins, okay?
So, if you look at that, if you add the fact that it’s with a Solo 401(k), there’s a loan option where you can borrow tax-free $50,000 or 50% of your account value, whatever’s less. Great. You can also do Roth if you don’t want to maximize deductions one year. SEP IRA is always pretax. Okay, what else? With a ,Solo K, if you want to do real estate, you can use leverage or a nonrecourse loan to buy real estate and not be subject to a tax known as unrelated business taxable income tax, which applies when a retirement account, an IRA I should say, uses a nonrecourse loan to acquire real estate. There is a specific exemption for 401(k) plans. Another win.
So. When you add all this together, that’s why I’m focusing on the Solo K on today’s podcast/video is again, if you have extra money lying around, you are eligible, you have a small business, you’re self employed, no full-time employees other than the owners or their spouses and you’re thinking deductions, deductions, deductions. When April 15 rolls around, I want to pay the least amount legally I have to. Massive opportunity to really reduce income. There’s charity, there’s whether you do a standard deduction or an itemized deduction. Maybe there’s state and local taxes, mortgage interest deduction. Maybe you have excess medical cost, God forbid, more than 7.5% of your adjusted gross income. But, the 401(k), the Solo K is just the easiest, most available massive deduction that you can tap into and $60,000+.
So, if you had a really good year; okay, yeah, I know the investment marketplace performed very poorly this year. Equities, cryptos, gold, even real estate. The last quarter hasn’t been great. I’ve seen my statement, and I’m sure you guys have seen your statements. I’m down this year. It’s been a pretty crappy year, but, business-wise, people are doing well. We saw unemployment numbers are still super low. Businesses are doing well. Yeah, maybe they’re raising prices, but generally most businesses are doing well. That means they’re still available money. If you did well, you’re going to want to generate deductions.
How do you generate deductions? 401(k) is a great way to do that. What are another, just one other tip, and I’ll probably do another podcast on this, I did a YouTube Live video last week on this, but every taxpayer that has any investment probably has losses this year, okay? So, that means you want to make sure that you talk to your accountant and before 12/31, you have the ability to use $3,000 of capital losses to offset ordinary income; up to $3,000. So, as long as you have some loser stock, which unfortunately we all do, at least everyone I’ve spoken to does, I spoke to one person actually, who claims that their hedge fund is up 1%, God bless them. But everyone else I’ve talked to, and I have lots of friends in the wealth management space at work, some of the largest banks in the world, they’re all down seven to 15%. So for all of us, it’s only $3,000, but it’s free $3,000 deduction, or let’s say you sell your Tesla, your Apple, whatever is down, and you just buy back 31 days later. Why 30 days? Because there’s a wash sale rule where you can’t buy back a lost position when you sell within 30 days.
So, when you add 401(k)s, when you have, if you’re going to itemize, charity, state and local taxes, mortgage interest deduction, the $3,000 capital to ordinary which is is available, even if you use the standard deduction, you can really start driving down your tax base. Which again, that’s the whole goal of this. We want to generate deductions. Credits are better, right? But credits are a lot harder to come by. What’s a credit? Credit reduces the amount you have to pay Uncle Sam dollar for dollar; where deductions reduces your taxable income amount, right? So, if you made $100K and you have a $20,000 deduction, you pay tax on $80K. A credit means, oh, I owe the IRS $10,000, but I have a $3,000 credit, so I actually only owe them seven. So credits are better, just much more difficult to come by. But deductions are still good. So, Solo K’s $61,000 or $67,500, if you max out, that’s a huge chunk and you don’t just get the deduction, right? With charity you get a deduction and the money, let’s say, goes to church or to a great organization which is super, super important and great, but with a 401(k) you also get the benefit from that. Yeah. Charity, you benefit too. Your church has more money or, or the Save the Kids fund has more money or your local school, all that’s great.
But, with a 401(k), the money actually is in your retirement plan so when you hit 59 and a half, you can live off that and you can benefit that; you can buy your kids a house and you can go on vacation, whatever you want. Buy yourself a car, right? Whatever you want to do, you can do it. So you get the two benefits, which not enough people understand. Tax deduction, current benefit today and down the road benefit of deferral, of having money in your retirement account that you could end up supplementing other income you have in your future, helping your family, yourself out, which obviously is the name of the game.
So, just want to again, focus on this. I’ve done obviously over the years, lots of podcasts and videos on on Solo Ks. But end of year, everyone, including myself, very good at procrastination, deflecting. Let’s kick it down the curb. We’ll deal with it next month. This is it! Time’s running out. Clock is ticking another 25 days or so, okay? This is it. We got to set it up before 12/31. Why? Because you want to take advantage and get your employee deferrals. You can set it up in ’23, but you’re only going to get the 20 or 25% employer contribution benefit for ’22. So why wait? Just set it up. You can pay. It’s a tax-deductible expense obviously if you pay through your business. Obviously, we’d love to help you set up a plan, but that’s not really the point of today’s podcast. The point is, hey, you need to understand what’s available.
The biggest issue people have is education. People don’t even know these deductions are available and that’s kind of what I want to do. That’s my charity is to say, hey, I went to law school, I got a Masters in tax law. I spent hundreds of thousands of dollars on my education. I worked for nine years at some of the largest law firms in the world. I’ve written eight books. I live, die and breathe this stuff every day. Okay? So, if I can share my knowledge with all you, we all win, right? People understand it’s not a zero sum game, right? I can benefit, so could you. We all can benefit from this education. That is the most important part. Reducing your tax base today and having as much money in your pocket down the road where you could enjoy your life and your family could benefit. And you can also leave an everlasting legacy to your family. So, by setting up a Solo K, that is the best way to generate current deductions and also potentially build a strong retirement future for you and your family.
So, that’s it. Kind of went longer than I wanted but this is a topic that’s near and dear to my heart. I really believe in the retirement system. It works. It’s why there’s bipartisan support. It’s why it’s really the only area where Republicans and Democrats agree and work together because it’s based off math. Humans can’t screw it up. Put money in retirement plan pretax, you get a deduction and your money grows without tax. You’re generally going to have more money in a tax deferred account than if you pay tax every year on your gains. So, common sense, my nine year old kid can understand it. The issue is no one talks to us about it. No one educates us. So, hopefully I can do that. I can use some of my tax background, my law, tax law background to help all of you to reduce tax. I love government. Well, I love this country, I don’t love big government. So if we could reduce and minimize the amount of money we give the IRS and the government and maximize the amount that we can keep for ourselves and our family, we all win. And that’s what I try to do. So, I’m going to share what I do with all you and hopefully help you guys out and your family.
So, thanks for listening. If you’re watching on YouTube, thank you. Don’t forget to thumbs up or leave a comment. I personally respond to all comments. It may take me some time, but I’ll get to them, so feel free, good, bad, indifferent, whatever. I love to hear from all you. Thanks again for spending some time with me today. I hope you are having an amazing holiday season, get to spend some great time with your family and friends and look forward to talking to everyone again next week. Take care and have an amazing, amazing day!