Author Topic: Solo 401k or SEP IRA? - Small Side Income  (Read 2759 times)

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Solo 401k or SEP IRA? - Small Side Income
« on: July 25, 2014, 08:32:12 AM »
Hi everyone! I am hoping to get some Mustachian advice on this topic.

I currently work full time for firm, and have access to a Traditional 401k. I am on track to max it out every year, but with this being the first year (and changing contribution % in March) I am only going to hit about 15k or so in it. My Roth is also being maxed.

I also recently starting doing promotional work on the side, from which I am usually paid as an independent contractor. I am considering opening a solo 401k to shelter this income from personal tax & self-employment taxes. I plan to make around 5k this year on the side and maybe around 10k next year.

Is a solo the best way to do this? I know that I will have to lower contribution from my full time employer, but (if I understand this correctly) I would be avoiding 'double taxation' if I place the 1099 income into the 401k instead of my full time, W2 income. As far as an SEP IRA, I am only allowed to put in the 'employer match' - should I consider this option because I am expecting a small amount of income? If I use the 1099 income to fund traditional IRA within the SEP and don't fund my Roth, is that basically the same thing as going the solo 401k route?

When should I think about classifying myself as an S-corp? Should I be making more to make this worth it?


Thanks for any advice!

Cheddar Stacker

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Re: Solo 401k or SEP IRA? - Small Side Income
« Reply #1 on: July 25, 2014, 10:02:25 AM »
I'm confused. I'll try to help, but there are a lot of confusing thoughts/questions here.

I know that I will have to lower contribution from my full time employer, but (if I understand this correctly) I would be avoiding 'double taxation' if I place the 1099 income into the 401k instead of my full time, W2 income.

I have no idea what you mean by double taxation here - are you referring to paying both halves of the SE/FICA taxes? Either you are W-2 and use a 401K, or you are 1099 and use a solo 401k/SEP type vehicle. Both do the same thing - defer federal (and state if applicable) income taxes. Neither gives you an inherent advantage over the other in tax savings that I'm aware of. The big difference between all of them is how much you are allowed to contribute annually and what the contributions are based on. Neither of them avoid double taxation.

My Roth is also being maxed.

Roth IRA? Roth 401K? Can you just do a traditional IRA contribution rather than creating a new vehicle?

I also recently starting doing promotional work on the side, from which I am usually paid as an independent contractor. I am considering opening a solo 401k to shelter this income from personal tax & self-employment taxes. I plan to make around 5k this year on the side and maybe around 10k next year.

So I'm not the leading expert on Solo 401k's, but I just did a lot more reading on them based on the bolded part above. In my experience preparing tax returns, if you are a sole proprietor or an LLC you don't get to deduct employer contributions to a retirement plan from the business operations. Maybe I'm missing something here, but I don't think a solo 401k by itself will help you avoid SE taxes. If anyone has evidence to the contrary I'd love to see it.

When should I think about classifying myself as an S-corp? Should I be making more to make this worth it?[/b]

Classifying as an S-Corp is an easy change that has advantages, but it also requires more annual paperwork. If you are sole-proprietor or LLC you can file all this activity on your Schedule C within your 1040. If you change to S-Corp you have to file an annual S-Corporation tax return, track your shareholder basis, and put the K-1 activity from he S-Corp into your 1040.

What an S-Corp can do for you is allow some SE tax avoidance, but usually only a small amount, and usually only to the extent that you have employees or equipment that you are earning a profit on. Any of the revenue earned solely by your efforts is considered earned income and therefore is technically supposed to be subject to SE tax. If you do an S-Corp and Solo 401k or Simple IRA, then you might/should be able to deduct the employer contributions to the plan against your SE income which would therefore reduce your SE tax.

As to when you should do this, the added complications (and possibly costs depending on how much of this paperwork you are comfortable doing) is a personal choice. You might want to calculate what the potential cost savings might be, then evaluate how much it might cost you in your time and/or professional fees to accomplish this. Then don't do it until you cross over the breakeven point.


I hope that's helpful and not too confusing. If I'm wrong about anything here, please feel free to correct me mustachians, but that's how I see this scenario.

bacchi

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Re: Solo 401k or SEP IRA? - Small Side Income
« Reply #2 on: July 25, 2014, 10:05:24 AM »
Either will work. Employee match/profit share into them. You might consider a Simple IRA, which would allow you to put in more than the match of 20%.

You won't be able to avoid unemployment taxes unless you have an S Corp. Using an S Corp to avoid SE taxes could be risky if you're hourly.
« Last Edit: July 25, 2014, 10:07:50 AM by bacchi »

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Re: Solo 401k or SEP IRA? - Small Side Income
« Reply #3 on: July 27, 2014, 07:43:33 AM »

I have no idea what you mean by double taxation here - are you referring to paying both halves of the SE/FICA taxes? Either you are W-2 and use a 401K, or you are 1099 and use a solo 401k/SEP type vehicle. Both do the same thing - defer federal (and state if applicable) income taxes. Neither gives you an inherent advantage over the other in tax savings that I'm aware of. The big difference between all of them is how much you are allowed to contribute annually and what the contributions are based on. Neither of them avoid double taxation.

Yes, that is what I was referring to - both halves of the SE/FICA taxes. The advantage I'm seeing with these accounts is the 'employer match' aspect. I've done more research, and it seems that the employer match only serves to reduce my overall AGI (which I'll gladly take) and I can have more cash working for me in the market even though it's not much (yet). :)

Roth IRA? Roth 401K? Can you just do a traditional IRA contribution rather than creating a new vehicle?

Roth IRA. I think I will just do the SEP which will allow me to contribute the match, since there won't be any additional tax avoidance by using either vehicle.


So I'm not the leading expert on Solo 401k's, but I just did a lot more reading on them based on the bolded part above. In my experience preparing tax returns, if you are a sole proprietor or an LLC you don't get to deduct employer contributions to a retirement plan from the business operations. Maybe I'm missing something here, but I don't think a solo 401k by itself will help you avoid SE taxes. If anyone has evidence to the contrary I'd love to see it.

You can contribute a profit sharing/employee match of 20% as a sole proprietor or LLC, 25% if you're a corporation.

This discusses the contribution limits for the self-employed - http://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans
Here's a worksheet that breaks down the maximum allowable amounts - http://www.irs.gov/publications/p560/ch05.html

Classifying as an S-Corp is an easy change that has advantages, but it also requires more annual paperwork. If you are sole-proprietor or LLC you can file all this activity on your Schedule C within your 1040. If you change to S-Corp you have to file an annual S-Corporation tax return, track your shareholder basis, and put the K-1 activity from he S-Corp into your 1040.

What an S-Corp can do for you is allow some SE tax avoidance, but usually only a small amount, and usually only to the extent that you have employees or equipment that you are earning a profit on. Any of the revenue earned solely by your efforts is considered earned income and therefore is technically supposed to be subject to SE tax. If you do an S-Corp and Solo 401k or Simple IRA, then you might/should be able to deduct the employer contributions to the plan against your SE income which would therefore reduce your SE tax.

As to when you should do this, the added complications (and possibly costs depending on how much of this paperwork you are comfortable doing) is a personal choice. You might want to calculate what the potential cost savings might be, then evaluate how much it might cost you in your time and/or professional fees to accomplish this. Then don't do it until you cross over the breakeven point.

Agreed. Currently, I don't think it's worth the added cost and hassle of setting it up. And I don't see the side income going very high in the future either.

I hope that's helpful and not too confusing. If I'm wrong about anything here, please feel free to correct me mustachians, but that's how I see this scenario.

This was helpful and confusing - but not because of you, because taxes. haha. It prompted a lot more research and I think I have the answers I need. Thank you!

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Re: Solo 401k or SEP IRA? - Small Side Income
« Reply #4 on: July 27, 2014, 07:46:39 AM »
Either will work. Employee match/profit share into them. You might consider a Simple IRA, which would allow you to put in more than the match of 20%.

You won't be able to avoid unemployment taxes unless you have an S Corp. Using an S Corp to avoid SE taxes could be risky if you're hourly.

Thanks! I will do more research on Simple IRAs to see if it's something that might work for me.