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Can a Solo 401(k) Reduce Self-Employment Tax?

Can a Solo 401(k) Reduce Self-Employment Tax?

One of the more common questions we receive from self-employed business owners seeking to establish a Solo 401(k) plan is whether it can reduce self-employment tax. The short answer is no.

In general, when one make a contribution to a Solo 401(k) plan, it’s typically after self-employment tax.

 
Key Points 
  • Solo 401(k) contributions are made after self-employment tax
  • Contributions will not lessen the tax you owe
  • The best way to shrink your tax burden is maxing out your pretax contributions

What is Self-Employment Tax?

According to the IRS, you are self-employed if you are a sole proprietor (including an independent contractor); a partner in a partnership (including a member of a multi-member LLC), or you’re in business by yourself. A sole proprietor also includes the member of a single-member LLC that is disregarded for federal income tax purposes and members of a qualified joint venture.

Usually, you must pay self-employment tax if you have net earnings from self-employment of $400 or more. Net earnings are calculated by subtracting ordinary and necessary trade or business expenses from the gross income you generate from your trade or business. You can be liable for paying self-employment tax even if you currently receive social security benefits.

If you are self-employed, your FICA tax rate for 2022 and 2023 is 15.3%. The self-employment rate is the sum of a 12.4% Social Security tax and a 2.9% Medicare tax on net earnings. For 2022, the first $147,000 of your combined wages, tips, and net earnings is subject to any combination of the Social Security part of self-employment tax, Social Security tax, or railroad retirement (tier 1) tax.

According to the Social Security Administration, if you have wages, as well as self-employment earnings, the tax on your wages is paid first. But this rule only applies if your total earnings are more than $147,000.

For example, if you will have $30,000 in wages and $45,000 in self-employment income in 2022, you will pay the appropriate Social Security taxes on both your wages and business earnings.

However, if your wages are $97,000, and you have $51,000 in net earnings from a business, you don’t pay dual Social Security taxes on earnings more than $147,000. Your employer will withhold 7.65% in Social Security and Medicare taxes on your $97,000 in earnings. You must pay 15.3% in Social Security and Medicare taxes on your first $50,000 in self-employment earnings, and 2.9% in Medicare tax on the remaining $1,000 in net earnings.

Self-Employment Can Lower Federal Income Tax

Net earnings from income tax are considered earned income. Income that you earn includes all the taxable income and wages from working. This can be as an employee, or from running or owning a business. It also includes other types of taxable income. Earned income includes:

  • Wages, salaries, tips, and other taxable employee pay
  • Net earnings from self-employment
  • Union strike benefits
  • Long-term disability benefits received prior to minimum retirement age

Therefore, establishing a Solo 401(k) plan will help you reduce federal income tax by making pretax deductions. However, it will not reduce self-employment tax.

For example, if Tom earns $50,000 in 2022, his self-employment tax would be approximately $7,065.  Whereas, if he earned $200,000 in self-employment income, the tax would be $23,584.

The Solo 401(k) for the Self-Employed

Who is eligible to set up a Solo 401(k) plan?

A Solo 401(k) plan is well suited for businesses that either do not employ any employees or employee certain employees that may be excluded from coverage. It is perfect for any sole proprietor, consultant, or independent contractor. To be eligible to benefit from the Solo 401(k) plan, investor must meet just two eligibility requirements:

  1. The presence of self employment activity.
  2. The absence of full-time employees.

The business owner and their spouse are technically considered “owner-employees” rather than “employees.”

What type of business can set-up a Solo 401(k)?

Any U.S. based legal business.  A business is an activity in which a profit motive is present and economic activity is involved.  If you are self-employed, then using a Schedule C to report income or expenses will work.  Note – if you report rental income on a Schedule E you will not be deemed to be in business since a Schedule E is for passive real estate or interest income.

Solo 401(k) Plan Advantages

The Solo 401(k) plan has become the most popular retirement plan for the self-employed for several reasons.

  • High Maximum Annual Contributions: In 2022, one can contribute up to $61,000, or $67,500 if you are at least age 50. Those numbers increase to $66,000 and $73,5000 respectively for 2023.
  • Loan Feature: The ability to borrow up to $50,000 or 50% of the account balance, whichever is less, to use for whatever purpose. The loan amount plus interest is paid back to the plan.
  • Investment Opportunities: The ability to make traditional, as well as alternative, asset investments, including stocks, mutual funds, real estate, metals and cryptos.
  • UBTI Exemption: If you plan on making real estate investments, the Solo 401(k) is not subject to the UBTI tax, when using leverage to buy the property.

Get in Touch

Do you still have questions regarding the Solo 401(k) self-employment tax, or how the Solo 401(k) plan can help you to save on taxes? Get in touch with IRA Financial directly by calling 800-472-0646.

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