Solo 401(k) Tax Credits Explained: Don’t Let Your CPA Cost You $1,500

Are you a self-employed individual considering setting up a solo 401(k)? You might be leaving money on the table if you or your CPA aren't clear about the available tax credits. This article will dive into a common misconception that could save you $1,500 on your taxes.

The Case of the Confused CPA

Imagine this scenario:

Client: “Hey, I just set up a solo 401(k). Can I claim that $1,500 tax credit I heard about?”

CPA: “Sorry, but you're not eligible. You're a highly compensated employee, so you don't qualify for the credit.”

Client: “But . . .  I'm the only employee. How can that be right?”

If this exchange sounds familiar, you're not alone. Many CPAs are confusing two different credits: the 401(k) Startup Cost Credit and the Auto-Contribution Credit. Let's clear up the confusion.

Understanding the 2 Credits

There are two distinct credits related to 401(k) plans that are often confused:

1. 401(k) Startup Cost Credit
2. Auto-Contribution Credit

Here's a comparison of these two credits:

The Auto-Contribution Credit: A Solo 401(k) Owner's Secret Weapon

Here's what you need to know about the Auto-Contribution Credit:

• It's available to solo 401(k) owners
• No employee other than the owner is required
• The plan must include an auto-enrollment feature
• You can claim up to $500 per year for three years
• It's part of the SECURE Act, separate from the Startup Cost Credit

Why the Confusion?

Many CPAs are familiar with the 401(k) Startup Cost Credit, which does require non-highly compensated employees. They mistakenly apply this rule to all 401(k)-related credits. However, the Auto-Contribution Credit has no such restriction.

How to Claim Your Credit

To claim the Auto-Contribution Credit:

1. Ensure your solo 401(k) plan includes an auto-enrollment feature
2. Use Form 8881 to claim the credit on your tax return
3. Consult with a provider familiar with this credit, like My Solo 401k Financial

A Hypothetical Scenario

Meet Dr. Sarah, a self-employed physician earning $300,000 annually. She sets up a solo 401(k) with auto-enrollment in 2024. Here's how the credit works for her:

• 2024 tax year: $500 credit
• 2025 tax year: $500 credit
• 2026 tax year: $500 credit

Total savings over three years: $1,500

More information here:

Solo 401(k) Questions

Key Benefit: Auto-Contribution Credit Is a Tax Credit, Not a Tax Deduction

Understanding the difference between a tax credit and a tax deduction is key to maximizing your tax benefits. A tax deduction lowers your taxable income, reducing the amount of income subject to tax. However, the actual savings depend on your tax bracket. For example, a $500 deduction in the 22% tax bracket only saves you $110 (22% of $500).

In contrast, a tax credit reduces your tax liability dollar-for-dollar. A $500 tax credit directly reduces your tax bill by $500, regardless of your income or tax bracket, making it significantly more beneficial than a deduction.

Example: tax credit vs. tax reduction

• Tax deduction: A $500 deduction at a 22% tax rate lowers your taxable income to $44,500 and results in $110 in tax savings.
• Tax credit: A $500 tax credit directly reduces your tax bill by $500, leaving you with more overall savings.

The Auto-Contribution Credit, available to solo 401(k) owners with an auto-enrollment feature, allows you to claim up to $500 per year for three years, saving you up to $1,500 over time. A tax credit, like the Auto-Contribution Credit, provides more substantial savings compared to a tax deduction, making it a valuable benefit for solopreneurs.

Can You Combine Both Tax Credits?

If you're a self-employed business owner sponsoring a solo 401(k), you might wonder whether you can claim both the 401(k) Startup Cost Credit and the Auto-Contribution Credit simultaneously. Unfortunately, the answer is no.

This is primarily because of the eligibility criteria for the 401(k) Startup Cost Credit. This particular credit is designed for businesses with non-owner employees. To claim it, the business must include at least one non-owner employee who is actively participating in the plan. The problem arises when considering the qualifications for a solo 401(k), which is only available to business owners without non-owner or non-spouse full-time W-2 employees.

In simpler terms, if you're running a self-employed business eligible for a solo 401(k), you automatically disqualify yourself from being eligible for the 401(k) Startup Cost Credit because you cannot have the non-owner employees required to claim it.

On the other hand, you may still be eligible for the Auto-Contribution Credit. This credit does not require any non-owner employees, and it can be claimed by solopreneurs. The catch here is that your solo 401(k) plan must include an auto-enrollment feature to qualify for this credit. If you meet these criteria, you can receive a credit of up to $500 annually for three years, totaling $1,500.

More information here:

Multiple 401(k) Rules – What to Do with Multiple 401(k) Accounts

The Importance of Maximizing Tax Credits

Understanding how to maximize your tax credits is a crucial part of running a self-employed business. For solopreneurs, the Auto-Contribution Credit can be a small but impactful way to offset the costs of setting up and maintaining a solo 401(k). Given that this credit can result in a total savings of $1,500 over three years, it’s worth the extra effort to ensure your plan includes the auto-enrollment feature.

At the same time, it’s vital to recognize when a tax credit is not available. Many business owners mistakenly believe they qualify for the 401(k) Startup Cost Credit when setting up a solo 401(k), only to find out later that they don’t meet the non-owner employee requirement. This can lead to frustration and missed opportunities to take advantage of the correct credits.

By understanding the nuances between the 401(k) Startup Cost Credit and the Auto-Contribution Credit, you can position yourself to reduce your tax liability effectively. Always stay informed of tax regulations and seek guidance from professionals to ensure you’re maximizing your benefits under the current laws.

The Bottom Line

Don't let confusion cost you money. If you're setting up a solo 401(k), make sure it includes the auto-enrollment feature, and don't forget to claim your Auto-Contribution Credit. It's a small detail that can make a big difference in your tax bill.

Remember, while many CPAs are still catching up with these newer provisions, you can stay ahead of the game by understanding the nuances of these credits. Always consult with a financial advisor or 401(k) specialist who's up-to-date on the latest tax laws to ensure you're maximizing your benefits.

Have you encountered confusion about solo 401(k) tax credits? Have you taken advantage of either credit?