End of Year Tax Planning
Learning out loud about solo 401K's, tax deductions, and angel investing distributions.
On way I like to use the uncommon sense section is to learn out loud about a problem I need to solve or a new area I want to investigate.
Today, it’s about end of year tax planning, and opening a solo 401K. So many folks have asked about solo 401Ks, that I have decided to share my thought process of why I am opening one this year.
Apologies in advance for the wonkiness!
As some of you might know, there are tax strategies to reduce your taxable income in any given year. At year’s end, you can evaluate a range of tools to reduce your income, some of which are below.
Retirement accounts (certain accounts)
Charitable contributions (i.e. donations to a non-profit)
Tax loss harvesting (i.e. selling investments that are worth less than the price you paid. You can deduct the loss up to $3K)
This year, I have two problems I need to solve.
I haven’t contributed to my retirement account
I received a distribution for a venture capital investment
A bit of context. I have the assumption that I make less today than I will during retirement. So, I invest in retirement accounts that are taxed today, not at retirement.
My annual income right now is about $120K. In 2024, I have access to an employer sponsored 401K, which I contribute to up until the 6% company match. 401K’s reduce your taxable income the year you contribute, but are taxed when you use the money in retirement.
Then, at the end of the year, I contribute to a Roth IRA up to the max amount of $7K (if I am able). Last year, I contributed the max amount with a backdoor Roth. Roth IRA’s do not reduce your taxable income, but they grow tax free.
I was planning to do so again this year. Except, I received a distribution from a prior venture capital fund.
Here’s the breakdown and my plan.
Please note, this has not been discussed with an accountant, and I could fully be wrong. This is not advice, just my own research and thought process!
$30K = Long term capital gain from investment i.e. investment held from longer than 3 years. Taxed at 15% long term capital gains rate for federal + 8.3% for California.
Important to note, does not actually change my tax bracket, and given it’s long term capital gains, the tax burden is $8,430 (it would be much higher if taxed as short term capital gains).
To offset my additional $30K in income this year, I plan to contribute to a traditional solo 401K. Total contribution is $69K for 2024.
This year, I can contribute $14K to retirement, which will reduce my total taxable income by $14K. For the above example, it should cut the tax burden of the above in half ($30K-$14K = $16K in income or roughly $3,728 in taxes).
After walking through this analysis, it’s not strictly necessary for me to open a solo 401K this year, especially given I won’t change tax brackets. In the end though, as my income grows, I can continue more to retirement over time.
As my dad likes to say, never let the (tax) tail wag the (business) dog. But, retirement accounts are strategic tools in your small business toolkit, especially as your business grows.