The year is drawing rapidly to a close, and many are trying to figure out how they can reduce their tax liability. This is typically the time of year when people go on a tax deduction binge, doing what they can to lower their taxable income. Some people had been holding off on tax deductions, waiting to see what would happen with taxes next year, but with the issue of the Bush era tax cuts resolved for the next two years, the green light has been given to do whatever is possible to get as many tax deductions as possible this year.

If you have a home business, one way you can lower your taxable income for 2010 is to open a solo 401k and make a contribution.

What is a Solo 401k?

Traditional employees often have access to the 401k at their workplaces, which offers them a chance to contribute pre-tax dollars into a retirement account where the earnings grow tax-deferred. Contribution limits are higher for a 401k than they are for an IRA, so this presents opportunities for traditional workers. Many home business owners try to increase their ability to contribute to a tax advantaged retirement account by using SEP-IRAs or SIMPLE IRAs. However, even these accounts, which offer higher contribution opportunities than Traditional or Roth IRAs, do not offer the contribution possibilities of a solo 401k.

A solo 401k is a lot like a regular 401k, but it offers some other advantages to the self employed. You can contribute as much as 100% of your compensation, up to $49,000 for 2010. It is true that a SEP-IRA allows contributions of up to $49,000 this year, but contributions are capped at 25% of compensation. You can also borrow against your solo 4o1k, to the amount of 50% of your balance, or $50,000 — whichever is smaller.

You can open a solo 401k if you have income from being self-employed. It is also possible to roll over your plan from an old job, or from your IRA, to a solo 401k. Just make sure you consult with a professional about the best way to do this. Once your money is in the solo 401k, it grows tax deferred, and has the same penalties and requirements as a more traditional version of the 401k (with the exception of the special loan you can take with a solo 401k). You do not have to make an IRS filing until your assets are more than $250,000. After that, you need to file Form 5500.

Who Can Benefit from a Solo 401k?

Those most likely to benefit from a solo 401k plan are those who operate their own home businesses with no help from outside their families. This is because when you make a maximum contribution to your account, you also have to make the maximum contribution to our employees’ accounts. This can make a solo 401k more of a burden for those who have employees. But, if you have a small home business, and you are operating with just yourself and your life partner, it might offer a good option to increase your tax deductions this year, and provide a vehicle for larger deductions in the future — while helping you build your nest egg.

This article was featured on the Carnival of Personal Finance.



Miranda is freelance journalist. She specializes in topics related to money, especially personal finance, small business, and investing. You can read more of my writing at Planting Money Seeds.