Taxes are likely the biggest drag on your financial freedom. One little-known retirement plan may be your best option to protect your income from the tax man.

Tax rates have soared over the last several years with top earners paying up to 39.6% of their income to the government. With ever larger deficits, you’re likely to see even higher rates in the future. The path to European-style taxation and paying the government more than you take home may not be as far-fetched as it once seemed.

That makes it all the more important to take advantage of every opportunity to defer or reduce your tax burden. While investors pour over annual financial statements to beat the market by a percentage point, you could save tens of thousands a year by using tax-advantaged retirement options.

And one particular retirement plan could help you protect more than any other available.

What is a Solo 401k?

A Solo 401k, also referred to as an individual 401k or a one-participant 401k, is a special retirement plan for self-employed individuals. Unlike other retirement plans, the Solo 401k is strictly for sole proprietors with no employees. Your spouse may contribute to the plan if they earn an income from the business but you cannot have any other employees.

As with other individual retirement accounts (IRAs), the Solo 401k can be structured as a traditional plan where money goes in and grows tax-deferred or as a Roth plan where you pay taxes now but have no tax liability on withdrawal.

The option to hold your Solo 401k in a traditional or Roth account is an important one in protecting yourself from taxes. Many people opt for the immediate satisfaction of writing off their current income by contributing to the traditional account, foregoing the opportunity to withdraw money tax-free in retirement. Instead, try contributing to both a traditional and Roth Solo 401k account to help balance your tax burden in retirement.

How to Protect Your Income with a Solo 401k

The biggest advantage to a Solo 401k compared to other retirement plans is the amount you can contribute. Most retirement plans including 401k, 403b and 457 accounts limit contributions to $18,000 for the 2015 tax year.

For a Solo 401k, you can contribute as both the employee and an employer. Beyond your maximum contribution of $18,000 as an employee, you can contribute up to 25% of your compensation for the employer share. Total contributions into the account can be up to $53,000 for both employee and employer. Not only do you shield your own income from personal income taxes but the amount contributed by the business is written off as an expense.

Contributions are discretionary, unlike other retirement plans that may require a set percentage of earnings to be contributed each year. That means you can stash away the maximum when business is good, protecting as much as possible from taxes, and reduce your contribution if business slows.

Since your spouse qualifies on the plan, you can stash away up to $106,000 a year and an additional $6,000 each on catch-up contributions for those 50 and older.

Even if you work for an employer, there may still be a way to cash in on this retirement tax shelter. If your employer is willing to change your status to that of an independent contractor then you can set up your own business and funnel income through it. The change raises a lot of issues like loss of corporate benefits and unemployment protection so you will need to think carefully about it. If you do elect for the change, make sure you negotiate an annual fee that is higher than your previous salary to make up for the lost benefits.

One disadvantage of the Solo 401k is that administration providers may restrict you to a limited choice of investment options. Fees can get expensive with set-up charges though you may be able to negotiate these lower.

When can I withdraw my money from a Solo 401k

Solo 401k plans are similar to other retirement options for withdrawals. You will need to keep your money in the plan until you reach 59 ½ years or older. Early withdrawal comes with a steep 10% penalty on top of the income taxes you will pay.

You may be able to make a penalty-free withdrawal early on the following circumstances:

• Purchase of first home
• Expenses for sudden disability
• Higher education expenses
• Payments to prevent eviction or foreclosure

Another advantage of the Solo 401k over other plans is the ability to borrow against your balance. Some providers will allow you to borrow on the account as long as the loan does not exceed $50,000 or 50% of the plan balance. Loan payments and rates will vary by provider.

At the top tax brackets, the Solo 401k may be able to save you thousands in taxes and tax benefits for your business. Few other retirement plans allow you to contribute as much and the option to contribute under both traditional and Roth plans can help balance your tax burden in retirement. Take advantage of this relatively unknown plan to protect as much of your income as possible.

David Michael White is a Sr. IRA Adviser with the Certified Gold Exchange Retirement Success Division. To speak with David or learn the many methods he has to save between 70% and 80% of your distribution tax, please call 1-800-300-0715 Ext. 721.

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