You have probably heard that having an S-Corp or an LLC taxed as an S-Corp is superior to a sole proprietorship. Usually, the supporting example is related to self-employment tax and limited liability. There is also one other element that is rarely discussed: retirement plan efficiency.
An S-Corp Solo 401k is much more efficient than one in a sole prop. This is because of how the maximum contribution is calculated. Let’s look at an example of each starting with the same amount of net income and see how it differs.
Sole Proprietorship
Let’s assume your net business income in your sole proprietorship is $100,000. First, you owe self-employment taxes and you deduct half of that. This leaves you with self-employment income of $92,935.23. Your maximum profit sharing contribution is 20% of that number, $18,587.05. You can also contribute $22,500 for your employee deferral. All together, you can defer income taxes on $41,087.05 of your income. That money is now available for tax-deferred investing until you withdraw it from your Solo 401k.
S-Corp
Now, let’s assume your same $100,000 net business income came through your S-Corp (or LLC taxed as an S-Corp). You decide to pay yourself the entire $100,000 as wages to increase your Solo 401k as much as possible. You still owe payroll taxes in the same amount as the self-employment taxes in the sole proprietorship example, of which half is deductible against your S-Corp’s net income. So far, you are in the same situation as the sole proprietorship, but this is where things change.
You can contribute 25% of your wages as profit sharing, $25,000. The profit sharing component is calculated differently in an S-Corp, which gives you the advantage. The employee deferral is still same, $22,500. All together you can defer income taxes on $47,500 of your income. That money is also now available for tax-deferred investing until you withdraw it from your Solo 401k. Now, you have a lower tax bill and more money available for tax-deferred investing. Pretty cool, huh?
Talk with your attorney and CPA and see how the switch from Sole Prop to S-Corp can enhance your bottom line without having to make any additional sales.