My wife and I are in a rather unique (for us anyway) situation this year. She lost her job at the end of January, and was given a lump-sum severance equal to nine months of her salary. The severance was taxed at the 25% bonus tax rate which means a huge chunk was withheld by the federal government. To make matters worse, there were no 401K contributions taken out of the severance amounts, meaning the full amount would be taxed.
In the middle of August, she got a new job with a salary roughly equal to what she was making before. Because we are carrying two mortgages and spent a large portion of our savings on a new (used) car, down payment for the new house and moving expenses we opted for her only to contribute enough to her new 401K to get the company match (dollar for dollar up to 6%). Since she started her new job in a period that was overlapped by her severance, her income will be a bit exaggerated this year (by nearly 25%).
We also received a large amount of relocation assistance from my wife’s new company, some of it was grossed up (money added to cover the taxes) and some was not. We also sold three horses this year and while we still won’t make a profit on the horse business (due to moving expenses) we’ll be close. In past years, the horse breeding business has shown significant losses.
My situation is also a bit different than normal. So far I’ve kept my job and continue to be paid my normal salary. I am just about maxing out my 401K for the year. A friend of mine acquired a new business and asked me for some help, so our nights and weekends over the last couple of months have been spent doing work (for pay) for him. This self-employment income on top of my usual web hosting income will amount to more than $15,000 for the year. We haven’t paid any taxes on this income yet (most of it was generated in the 4th quarter anyway) and will eventually owe both income tax and self-employment tax (social security) on the amount.
In thinking through all of this, I remembered a post that Jonathan at MyMoneyBlog had done earlier on solo 401Ks vs. SEP IRAs. At the time I read the article I didn’t have enough self-employment income for a self employed retirement plan to be worthwhile. This year will be different however.
Self employed business owners can contribute up to 100% of their first $15,000 of compensation in 2006 ($20,000 if age 50+). Compensation is defined as W-2 wages if incorporated or self employment income if a sole proprietorship. In addition, a profit sharing contribution is permitted in a solo 401k. Profit sharing contributions of up to 25% of W-2 compensation for incorporated businesses or 20% of self employment income for sole proprietorships can also be made into a solo 401k. The maximum allowable contribution ($44,000 and $49,000 if you are age 50+ in 2006) simply takes the salary deferral contribution and adds the profit sharing contribution amount to it and that’s the total allowable contribution.
So, since my wife and I are both involved in the business (you can include your spouse but not other employees in a solo 401K plan) we could defer as much as $44,000 each if we had enough self-employed income. We unfortunately won’t have that problem, but this is a powerful way to save more for retirement and cut down our tax bill. I will have come close to hitting the $15,000 limit for salary deferral through my employer’s 401K plan. My wife however will likely end up with only $5,000 or less in salary deferral contributions between her old and new employers. Assuming for simplicity’s sake that is a correct figure, she should be able to defer another $10,000 in income into her solo 401k, we would then both be able to take 10% of the business’ profits (20% total) and contribute that amount as well. In this way, we can take our $15,000 (estimated) self-employment income and defer taxes on the majority of it (after self-employment taxes). I won’t be able to contribute much to mine this year, but every little bit helps!