How Small Business Owners Can Slash Their Tax Bill by $20,000+ With a 401(k)

What if you could redirect $20,000 or more from your tax bill directly into your own retirement account—every single year?

For small business owners, this isn't a hypothetical. It's exactly what a well-structured 401(k) plan can accomplish. While your W-2 employee friends are capped at contributing $24,500 in 2026, you can contribute up to $72,000—or even $80,000 if you're over 50. And every dollar you contribute reduces your taxable income.

Yet many business owners leave this money on the table, either because they don't know these plans exist or they assume setting one up is too complicated. The reality? Solo 401(k) plans can be established in under an hour, often with no setup fees, and the tax savings start immediately.

How 401(k) Plans Reduce Your Taxes

The tax benefit of a 401(k) is straightforward: traditional contributions come directly off your taxable income. If you're in the 32% federal tax bracket and contribute $50,000 to your 401(k), you save $16,000 in federal taxes alone. Add state taxes, and the savings climb even higher.

Here's what makes 401(k)s particularly powerful for business owners:

You wear two hats. As both employee and employer of your business, you can make contributions in both capacities. This dual role unlocks contribution limits far beyond what traditional employees can access.

Employee contributions (salary deferrals) allow you to set aside up to $24,500 in 2026 from your compensation. This comes directly off your taxable income.

Employer contributions (profit sharing) let your business contribute up to 25% of your compensation on top of employee deferrals. These contributions are tax-deductible business expenses.

The combined limit for employee plus employer contributions is $72,000 in 2026. If you're 50 or older, catch-up contributions add another $8,000, bringing your potential total to $80,000.

For those aged 60-63, a "super" catch-up provision allows an additional $11,250 instead of the standard $8,000—pushing the maximum to $83,750.

Understanding Contribution Limits (2025-2026)

Contribution Type	2025	2026
Employee Deferral	$23,500	$24,500
Combined (Employee + Employer)	$70,000	$72,000
Catch-up (Age 50+)	$7,500	$8,000
Super Catch-up (Ages 60-63)	N/A	$11,250
Maximum with Catch-up	$77,500	$80,000
Maximum Compensation Considered	$350,000	$360,000

These limits apply across all 401(k) plans you participate in. If you have a day job with a 401(k) and run a side business, your employee deferrals are combined across both plans.

Solo 401(k): The Best Option for Most Small Business Owners

If you're self-employed or run a business with no employees (other than a spouse), the Solo 401(k)—also called an Individual 401(k) or One-Participant 401(k)—is typically your best choice.

Why Solo 401(k) Beats Other Options

Higher contribution potential than SEP IRAs. With a SEP IRA, you can only make employer contributions (up to 25% of compensation). A Solo 401(k) lets you also make employee deferrals, often resulting in significantly higher total contributions—especially at moderate income levels.

Consider someone earning $100,000:

• SEP IRA maximum: $25,000 (25% of compensation)
• Solo 401(k) maximum: $49,500 ($24,500 employee + $25,000 employer)

That's nearly double the tax-deferred savings.

Roth option available. Solo 401(k)s can include a Roth component, allowing after-tax contributions that grow tax-free. SEP IRAs don't offer this flexibility.

Loan provisions. Most Solo 401(k) plans allow you to borrow from your account—up to $50,000 or 50% of your balance—for major purchases or emergencies. SEP IRAs don't permit loans.

Catch-up contributions. Available with Solo 401(k)s but not with SEP IRAs, adding another $8,000 in potential contributions for those 50 and older.

When SEP IRA Makes Sense

SEP IRAs shine in specific situations:

Simplicity matters most. SEP IRAs require almost no administration. There's no annual IRS filing requirement (Form 5500) until your plan exceeds $250,000.

You have employees. If you employ people beyond yourself and your spouse, SEP IRAs allow you to include them with straightforward contribution rules—though you must contribute the same percentage for all eligible employees.

Late setup. SEP IRAs can be established and funded up to your tax filing deadline (including extensions), while Solo 401(k)s must be established by December 31 of the tax year you want to contribute for.

Calculating Your Maximum Contribution

The math depends on your business structure:

If You're a Corporation (S-Corp or C-Corp)

Your contributions are based on your W-2 wages from the corporation.

Employee deferral: Up to $24,500 (2026), limited to your actual W-2 wages Employer contribution: Up to 25% of your W-2 wages Combined maximum: The lesser of $72,000 or your W-2 wages

Example: If your S-Corp pays you a $120,000 salary:

• Employee deferral: $24,500
• Employer contribution: $30,000 (25% of $120,000)
• Total: $54,500 in tax-deferred contributions

If You're Self-Employed (Sole Prop, Partnership, LLC)

The calculation is more complex because your "compensation" for retirement plan purposes is your net self-employment income minus half of your self-employment tax, then reduced by the contribution itself.

The effective employer contribution rate works out to approximately 20% of net Schedule C income (rather than 25% for corporations).

Example: If your Schedule C shows $150,000 net profit:

• Employee deferral: $24,500
• Employer contribution: ~$27,900 (approximately 20% after adjustments)
• Total: ~$52,400

Use IRS Publication 560 worksheets or retirement plan calculators to determine your exact maximum.

Tax Credits That Sweeten the Deal

Beyond contribution deductions, the IRS offers tax credits specifically for small businesses offering retirement plans:

Startup Credit (Form 8881)

If you're establishing a new plan, you can claim a credit of up to $5,000 per year for three years to offset startup and administrative costs.

Eligibility: Businesses with 50 or fewer employees receiving at least $5,000 in compensation can claim 100% of eligible costs. Businesses with 51-100 employees claim 50%.

Auto-Enrollment Credit

Adding automatic enrollment to your plan triggers a separate $500 annual credit for three years. This applies even to existing plans that add auto-enrollment.

Employer Contribution Credit

New under SECURE 2.0, this credit helps offset the cost of employer contributions for employees earning under $100,000. The credit phases in over five years.

These credits are separate from your contribution deductions—you can claim both (though you can't deduct expenses you've already claimed as credits).

Important 2026 Change: Roth Catch-Up Requirement

Starting in 2026, SECURE 2.0 changes how catch-up contributions work for higher earners:

If your prior-year wages exceeded $150,000, your catch-up contributions must be made as Roth contributions—meaning they won't reduce your current taxable income.

This affects only the catch-up portion ($8,000 or $11,250), not your regular employee deferrals or employer contributions. And it only applies to employees whose W-2 wages exceeded $150,000 the previous year.

Business owners paying themselves under $150,000 can continue making pre-tax catch-up contributions.

Setting Up Your Plan

Solo 401(k) Setup

1. Choose a provider. Major brokerages like Fidelity, Schwab, and Vanguard offer free Solo 401(k) plans. Some providers charge annual fees but offer more features (like Roth and loan provisions).

2. Complete plan documents. Your provider supplies an IRS-approved plan document and adoption agreement. This typically takes 15-30 minutes.

3. Establish by December 31. The plan must be established by year-end to contribute for that tax year. Employee deferrals must be made by December 31; employer contributions can be made until your tax filing deadline.

4. Open the account. Fund it like any brokerage account.

SEP IRA Setup

1. Complete IRS Form 5305-SEP or use your financial institution's plan document.

2. Set up individual accounts for yourself and any eligible employees.

3. Contribute by your tax deadline. SEP IRAs can be established and funded up to your tax filing deadline, including extensions.

Strategies to Maximize Tax Reduction

Max Out Employee Deferrals First

Employee deferrals come directly from your paycheck and reduce your taxable income dollar-for-dollar. Make sure you're contributing the full $24,500 (2026) before worrying about employer contributions.

Time Your Employer Contributions

Employer contributions can be made up until your tax filing deadline (including extensions). This gives you flexibility to:

• See your final year income before deciding on contribution amounts
• Ensure you have sufficient cash flow
• Coordinate with other tax planning strategies

Consider Roth Contributions

If you expect to be in a higher tax bracket in retirement—or if you want tax-free growth and withdrawals—consider making some contributions as Roth. You won't get the immediate tax deduction, but qualified withdrawals are completely tax-free.

Combine With Other Strategies

A 401(k) can work alongside other tax reduction strategies:

• HSA contributions if you have a high-deductible health plan
• Business expense deductions timed strategically
• Income timing to stay within favorable tax brackets

Common Mistakes to Avoid

Missing the establishment deadline. Solo 401(k) plans must be established by December 31 to contribute for that year. Don't wait until tax time.

Exceeding contribution limits. Over-contributions trigger a 6% excise tax. Track limits carefully if you participate in multiple plans.

Forgetting Form 5500-EZ. Solo 401(k) plans with assets exceeding $250,000 require annual IRS filing. Miss it and face penalties.

Ignoring the Roth option. Tax diversification matters. Having both pre-tax and Roth retirement funds gives you flexibility in retirement.

Not adjusting for business structure. The 25% employer contribution limit applies to corporations. Self-employed individuals effectively contribute about 20% due to the calculation methodology.

Taking Action

If you haven't set up a retirement plan for your business, you're leaving significant tax savings on the table.

Before December 31:

1. Decide between Solo 401(k) and SEP IRA based on your situation
2. Open an account with a major brokerage
3. Complete the plan documents
4. Make your employee deferral contributions

Before your tax deadline:

1. Calculate your maximum employer contribution
2. Fund the employer contribution
3. Keep records for your tax return

The math is compelling: a business owner in the 32% federal bracket contributing $50,000 saves $16,000 in federal taxes immediately. Add state taxes and decades of tax-deferred growth, and you're looking at hundreds of thousands of dollars in lifetime benefit.

Your future self will thank you.

Track Your Retirement Contributions Accurately

Maximizing 401(k) contributions requires precise tracking of your business income, compensation, and contribution amounts. Errors can lead to over-contribution penalties or missed deductions.

Beancount.io provides plain-text accounting that gives you complete transparency over your financial records. Track your business income, owner's compensation, and retirement contributions with auditable precision—everything you need for accurate tax planning and IRS compliance. Get started for free and take control of your retirement planning.