Solo 401(k) vs. Self-Employment Tax Question

Solo 401(k) vs. Self-Employment Tax Question
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#1

My wife was forced to leave her job earlier this year after contributing $7,350 to her (civ) TSP. She has a hobby that we estimate could generate $7,500 net profit by the end of the year if she wanted it to put forth the effort. If she were to set up a Solo 401(k), we have figured out that it would cost $530 in self-employment tax for the ability to contribute $6,970 (all of the income).

Is this worth doing even though the earnings are not enough to take advantage of the extra “employer contribution” amount?


#2

Not sure you’re right about the numbers, I see over $1k in SE tax. You’d also still owe some income tax on 7.65% of the net income.


#3

I found the easiest way to answer these what-if scenarios is to use a copy of last year’s TurboTax (or whoever). Input your prior year’s data and test out the scenarios.

This is especially important with bigger numbers that trigger AMT or the Medicare 3.8% tax.


#4

I don’t really know what I’m doing but I used this calculator to get the $6,970 number. The SE Tax is $1,060 but I am assuming it is this way because half is deductible. Is that not correct?

Thank you for the info about the income tax.


#5

Good idea, thank you.


#6

Sorry, I misread your post. If you contribute 6,970, you wouldn’t owe income tax. But the cost of the 7,500 income is $1,060 because that’s what you’re paying in taxes. If you contribute $6,440 ($7,500 - 1,060) you would owe income tax on the $530.


#7

Ok, got it. So I think my question now is, would you pay ~$550 to contribute the difference into a 401(k) at 40 years old? I know the answer for a taxable account.


#8

You can contribute up to 93% of self employment income to a solo 401(k) (up to a max of around $50k).

You will owe 14.1% (technically 15.3% of 92.35%) self employment tax on any amount you earn (it goes down above $127k). Half of that is deductible from your income tax. Self employment tax is not income tax. The non-deductible portion is the portion you can’t contribute to a solo 401(k) either, which is why it maxes at out 93%.

If you have $7,500 of self employment income (remember that is net income, if you are in self employment, there are lots of additional deductions you might be able to take to reduce that number):

$7,500 (net business income)
$1,060 (rounded) of self employment tax - all must be paid
$6,970 contribution to a solo 401(k)

-$530 (net cash in hand)

On your income tax side:
$7,5000 (additional reported income)
-$530 (deduction for 1/2 of self employment tax)
-$6,970 (deduction for solo 401(k))

$0 (net taxable income)

So at the end of the day, if you earn $7,500 in net self employment income, you will owe $1060 in self employment taxes and be able to contribute $6,970 to a solo 401(k). You will owe no additional income tax if you contribute the max to the 401(k).


#9

I don’t understand this question. You don’t pay anything to contribute to the 401(k). You are paying $1060 because you earned self employment income. You would owe that whether you contribute to the 401(k) or not.

You would also owe income taxes on that $7,500 at your marginal tax rate. By contributing it to the 401(k) you avoid paying the income tax.

Solo 401(k)'s have much higher contribution limits so the amount contributed to the previous plan isn’t relevant.

Are you asking, “is it worth it to earn money even though you have to pay taxes on it?”. Or are you asking if you should contribute only 86% to the 401(k) instead of the max of 93%, so the self-employment income would be sufficient to cover the full self-employment tax liability? If so, it really depends on how much you need the $530 now and what your marginal tax rate is.

But at that point, why stop there? If it makes more sense to only contribute 86% instead of 93%, why not contribute only 80%, or 50%, or 0%? You could contribute only 50% to the 401(k) and pocket the rest (after paying income tax).


#10

Thank you for taking the time to post the breakdown of the numbers. And good points in your 2nd post. The issue is really that there would be a serious amount of effort to get to that point… the amount of effort that I would say is probably not normally worth pulling in just $7,500 net. It is hard to quantify that here, so I was trying to focus on the financial aspect of it to get a sense of the value of the ability to put that amount into a solo 401(k).

So maybe the question should have been… is it worth it to bust your ass for $7500 just for the ability to contribute the net income into a Solo 401(k) after paying SE tax?

FWIW, the background of this is that we live in a foreign country where she is only be allowed to work for the US Embassy due to our visa/dip status. That’s not an option for a few reasons, but she does have the ability to start a home-based business. That’s pretty much it.


#11

That changes things quite a bit. First, I would ignore the 401(k) in the question “is it worth it to bust your ass for $7,500?” That is a simple how much is her time worth and how much time would it take. The 401(k) part just means she would be able to keep more of the $7,500 by avoiding income tax on that amount.

Which brings up the international part. Your income tax liability is probably very low or zero as a single income marriage with an international income exclusion. In that situation I would absolutely NOT put it in a 401(k). When you withdraw it, you would owe income tax. By then you will probably be back in the US and have other taxable sources of income, and would end up paying more in taxes.

While living overseas, this is your opportunity to put as much money into ROTH as possible, be it ROTH IRAs or 401(k). I would look at other strategies like rolling over the existing 401(k) or IRAs (yours and hers) into an IRA that you can start converting to a Roth IRA. I would also look at maximizing your ROTH IRA contributions. One complication is that you can’t contribute more to a Roth IRA than your taxable earned income. (i.e. all of your excluded foreign earned income doesn’t count).

So, if her side business can be considered as earned in the US, then she could contribute to hers (and your) Roth IRAs. If her income is considered foreign earned, then she gets her own exclusion so no income taxes would be owed anyway. In either case, putting the money in a traditional 401(k) is sub-optimal.

If you can make it US earned income, then it would would be taxable in the US, but if you aren’t doing a lot of conversions, it would be below your standard deductions anyway and you wouldn’t owe any income tax.

If you are making a lot more than the foreign earned income exclusion (more than 6 figures) and it is considered US earned income (so she doesn’t get her own exclusion) so that you would owe income taxes in the US (the only possible scenario where putting it in a 401(k) could save you money), then I suggest that it isn’t worth her time to bust her ass and she should enjoy living overseas more.

TL;DR - For someone living overseas - (1) don’t put any in a traditional 401(k), (2) put as much into ROTH accounts as possible, (3) if you would owe income tax on it, then it is probably best not to do the self employment and just enjoy the foreign culture.


#12

Thank you for another outstanding post. This is perfect info, especially how important it is to maximize Roth contributions when your income is temporarily lower. Unfortunately it won’t work for our situation… and I feel bad, it’s like there’s always something more I should have said but didn’t know to.

As far as I can tell, we don’t (and won’t?) qualify for the foreign earned income exclusion. We file joint a return and I am US military… in that case is the spouse able to get their own exclusion for their income? She also joined me here March 1st, and it looks like you need to be there 330 days before becoming eligible anyways. IRS Eligibility Chart

Finally, we both already fully contribute to Roth IRAs each year, and I will max my TSP. She only had contributed $7,350 in her TSP this year. I wanted to see if we could find a way to not miss out on the $10,650 remaining in the 401(k) limit this year, but the best she can do within three months is at best guess about $7,500. Then with the SE Tax, and the hassle of setting up a new Solo 401(k)… trying to see if you guys think it’s worth it in exchange for the long-term tax benefit of that amount. I hope all that makes sense…? Or am I really off base?


#13

She could qualify for the foreign earned income exclusion. Your military income won’t. For the first year, the physical presence test could be used. If you never take trips back to the US, then she would meet the physical presence test around Feb 1st, 2018. If you travel to the US less than 30 days, then she would meet requirement on March 1st 2018. Meeting the requirement is retro active. All of her income (below the limit) from March 1st, 2017 forward could be excluded. FYI - when I first moved overseas, I moved in July. I got that income from Jul-Dec excluded, by filling for a 4 month extension until after I met the physical presence test.

Even if she does meet the physical presence test, where is the income earned? If she is selling items to US residents and collecting payment in the US, then it is probably US earned income. In which case the presence test doesn’t apply. Can she legally run a home business in the country you are in? If it is US earned income, then the presence test and exclusion aren’t relevant.

The solo 401(k) discussion is completely unrelated to the 401(k) limit. By using a solo 401(k) you aren’t taking advantage of any of that $10,650. It is completely irrelevant. She could have contributed the full $18k in her 401(k) and still opened the solo 401(k) and contributed an extra $7000. They are separate limits and the solo 401(k) are much higher because you can make employer contributions.

Break it down:

  1. Is it worth her time to build the at home business with the expected returns of the business? If yes, go to #2.
  2. Is the self employment income subject to US income tax?
  • No - then just put it in the bank and keep it as post tax money (there is no solo Roth 401(k)s as far as I can tell)
  • Yes - consider putting it into a solo 401(k)

Do not proceed to #2 until you have answered #1.


#14

You’re right, the majority of the work she would do will be for customers in the US. So that makes that part easy. Thank you for your perspective, I appreciate the time it took.


#15

Right. I interpreted the original post to say the total SE tax was $530 and the amount OP was contributing was $7,500 minus the total SE tax which would result in taxable income (conceptually, but I’m not particularly familiar with the calculations). Thanks for detailing out those calculations.