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I have been reading up on Solo 401k plans, thinking I might start one for myself. From what I see, there is a quasi-loophole that could be useful for tax planning. If I understand how Solo 401ks work, they have these crucial features:

  1. You can contribute up to 100% of your self-employed income or the max contribution ($18k), whichever is less.
  2. You can make your contributions whenever you wish, any time between January 1 of the tax year and your tax filing deadline for that tax year (i.e., April 15 of the following calendar year).
  3. Although you cannot contribute more than your self-employed income, the fungibility of money means that it doesn't matter where the actual dollars that you contribute come from, as long as you don't contribute too large an amount.

The combination of #1 and #2 seems to make the Solo 401k a uniquely advantageous account option. Unlike a regular 401k, you don't have to decide ahead of time how much to contribute via salary deferrals; you can wait until tax time approaches and deposit whatever amount you choose to optimize your tax situation. Combined with #3, this would seem to allow a certain sort of multi-year tax hedging strategy, where you can invest money in taxable accounts during flush years, and then sell those investments to save on your taxes during years when you don't have enough income to afford making the max contribution, while simultaneously shifting the taxable investments to tax-deferred status without paying taxes on any intermediate gains.

What I'm envisioning works like this: Suppose in a certain year you have a taxable income of $X, and suppose this has been a lean year, so you can't afford to make the max contribution to your Solo 401k. What you do is sell some investments from your taxable account. Suppose that these investments have a cost basis of $B and a gain of $G, so that you wind up with $B+G but only $G is taxable. Now you can contribute the entire $B+G to the Solo 401k. Although selling the investments only increased your taxable income by $G, contributing to the Solo 401k allows you to deduct the full amount of $B+G from your taxable income (assuming that this amount, together with whatever else you contributed, is less than your max allowable contribution). The end result is that you have made a net reduction of $B in your taxable income, reducing it to $X-B (thus saving on your taxes during this lean year), while transferring $B+G from taxable into tax-deferred accounts.

My question is, can you really do this, or is there something I'm missing? It seems plausible to me, because you are not really dodging any taxes this way over the long term, only shifting income from one year to another (as in various other aboveboard tax-avoidance strategies). The scheme gains you nothing if you already can afford to make the max contribution every year. Also, in order to use the scheme, you have to have money in taxable accounts to use as "fodder" during the lean years. And of course you need to sell the right amount of taxable investments so that you max out your allowable contribution.

However, even with these limitations, this seems like it could be a useful tax-management strategy. Self-employed people often have income that fluctuates from year to year. During a flush year, you could invest a bit of money in taxable accounts as a precautionary hedge against the future. Later, during a lean year, you could draw on that money as described above to reduce your tax bill. Also, if the flush year was so flush that you could have afforded to put more than the contribution cap (i.e., more than $18k), this strategy would allow you to "make it up later" by selling your taxable "reserve" and moving it into the Solo 401k effectively tax-free. Also, because the Solo 401k allows you to make the contribution at any time, you can do the necessary calculations at your leisure after the tax year is over, when you have all the info in hand to decide what arrangement will be most beneficial for you.

I'm ignoring some other wrinkles that could exist, like Solo 401k "employer nonelective contributions", but I don't think these affect the basic idea of what I'm describing here. So, is this a reasonable strategy?

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    Wash sale rules are still there you know, if you sell at loss at taxable account and then deposit into 401k to repurchase the investment - you'll have a problem there. Your basis in the 401k will essentially be negative. – littleadv Jun 7 '15 at 8:42
  • A wash sale involving the purchase of the replacement shares inside a retirement account is a lost ability to take the loss. The retirement account doesn't benefit from any basis adjustment. (You knew this, I'm sure, "essentially be negative" was a euphemism?) – JTP - Apologise to Monica Jun 7 '15 at 15:09
  • @JoeTaxpayer yes, what I meant was that there's no way to ever deduct that loss. – littleadv Jun 8 '15 at 4:06
  • That is true, although here I'm discussing selling for a gain. Also, you could still avoid the wash sale via the usual method of waiting a month, as long as you made the sale at least a month before the contribution deadline. – BrenBarn Jun 8 '15 at 4:09
  • I figured as much from your post, but littleadv' warning is appropriate. It's too easy to have a situation where you're selling for a loss to raise the cash to make the 401(k) deposit, and aren't paying enough attention to basis or losses. (Maybe not you, but a future reader) – JTP - Apologise to Monica Jun 8 '15 at 9:37
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What is the question? Are you just trying to confirm that for self-employed, a Solo 401(k) is flexible, and a great tool to level out your tax rates? Sure. A W2 employee can turn on and off his 401(k) deduction any time, and bump the holding on each check as high as 75% in some cases. So in a tight stretch, I'd save to the match, but later on, top off the maximum for the year.

To the points you listed -

  1. Same as a standard 401(k)
  2. Solo is more flexible, especially for the opportunity to deposit until April.
  3. Not really different - you can save to your 401(k), but spend from savings or liquidated investments.

Your observation is interesting, but a bit long for what you seem to be asking. Keep in mind, there are 2 great features that you don't mention - a Roth Solo 401(k) flavor which offers even more flexibility for variable income, and loan provisions, up to $50,000 available to borrow from the account. My fellow blogger The Financial Buff offered an article Solo 401k Providers and Their Scope of Services that did a great job addressing this.

  • In essence, yes, I guess. It just seems to me that the flexibility of the Solo 401k makes it radically different from other kinds of retirement accounts. I've seen lots of blogs and sites about Solo 401ks, but they all basically just said, "It's like a 401k for yourself", and none mentioned that the ability to deposit whenever you like makes it far more useful than a regular 401k. So I wondered if I was missing something. Doing this kind of management with an ordinary 401k is much trickier, since you can't change deferrals on past paychecks. – BrenBarn Jun 7 '15 at 17:57
  • Got it. I think for anyone with self employment income, it's a great plan. The idea that you can decide on $18K Roth or Traditional on April 15th is pretty cool. Are you self employed, or now, just wish you were? – JTP - Apologise to Monica Jun 7 '15 at 18:34
  • I have both wage income and self-employment income, and have been looking at starting a Solo 401k for the self-employment income. – BrenBarn Jun 7 '15 at 20:02
  • I understood that #1 and #2 are incompatible. Contributions under the employee hat can be up to 100% of self-employment-taxable earnings (or the cap), but have to be made during the calendar year. Contributions under the employer hat can be made until filing taxes, and have a much higher cap, but are limited to a much smaller percentage, in the range of 20-25%. Is my understanding too restrictive? – Ben Voigt Feb 16 at 5:47
  • @BenVoigt - see schwab.com/cms/P-2979736.2 page 2. Yes, the 'employer' hat is a bit restrictive, but at a low income, not really. – JTP - Apologise to Monica Feb 16 at 12:59

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