Solo 401k contributions to a Checkbook-Control Qualified Retirement Plan – a Checkbook QRP – have multiple tax benefits: (1) They are tax-deductible, reducing your taxable income & tax liability to the IRS and (2) they grow tax-deferred, with no annual taxes on earnings and profits within the Solo 401k.
Tax-deductible Solo 401(k) contributions consist of 2 components: (1) Employee Elective Deferrals and (2) Employer Non-Elective Contributions (profit sharing). However, you may have heard various other terms used to describe 401(k) Plan contribution types. Following is a comprehensive guide to Solo 401k contributions, terms, and calculations.
Solo 401k Employee Contributions
1) Solo 401k Employee Elective Deferrals are amounts contributed to a plan by the employer at the employee’s election and which, except to the extent they are designated Roth contributions, are excludable from the employee’s gross taxable income. Elective deferrals include deferrals under a 401(k), 403(b), SARSEP and SIMPLE IRA plan.
2) Solo 401k Catch-up contributions are a subset of Elective Deferrals. If permitted by a 401(k), 403(b), governmental 457(b), SARSEP or SIMPLE IRA plan, participants who are age 50 or over at the end of the calendar year can also make catch-up elective deferral contributions beyond the basic limit on elective deferrals.
3) 401(k) Designated Roth contributions – aka “Roth Deferrals” – are a type of elective contribution that, unlike pre-tax elective contributions, are currently includible in gross taxable income but totally tax-free when distributed. In other words, Designated Roth contributions are elective deferrals that the participant chooses to include in current gross income in exchange for receiving earnings on those contributions totally tax-free forever.
4) Solo 401k Voluntary After-Tax Contributions are contributions from compensation (other than Roth contributions) that an employee must include in current income on his or her tax return. If a Solo 401k plan allows after-tax contributions, they are not excluded from income and an employee cannot deduct them on his or her tax return. However, earnings on such contributions grow and compound without the drag of annual taxation of earnings. Taxation of earnings on such contributions is only deferred. In contrast, earnings on Roth Contributions are TAX FREE. A Solo 401k Mega Back Door Roth IRA Strategy can be executed to convert tax-deferred 401k voluntary contributions to tax-free 401k Roth funds.
Solo 401k Employer Contributions
5) Solo 401k Employer Matching Contributions. If the plan document permits, the employer can make matching contributions for an employee who contributes elective deferrals (for example, 50 cents for each dollar deferred). Employer matching contributions can be discretionary (contributed in some years and not in others, depending on the company’s decision) or mandatory, as in SIMPLE plans and Safe Harbor 401(k) plans.
6) Solo 401k Employer discretionary or nonelective contributions, often referred to as Solo 401k profit-sharing contributions. If the plan document permits, the employer can make contributions other than matching contributions for participants – regardless of whether or not they make elective deferrals. These contributions are made on behalf of all employees who are plan participants, including participants who choose not to contribute elective deferrals.
For Solo 401k tax-deduction purposes, the focus is on contributions types 1, 2, and 6, above.
Solo 401k Employee Deferral Elections
As indicated by their name, Solo 401k Employee Elective Deferrals apply to compensation that would become available to an employee but for the employee’s election to defer receipt – and thus taxation – of such income. Accordingly, deferral elections can only be before it is actually available to the employee. Once the income is available to the employee, taxable income must be recognized. Therefore, the deferral election must be made before that point is reached. 26 CFR 1.401(k)-1.
- For an employee that is paid a W-2 wage, the election must be effective prior to the payroll upon which they would be compensated for their services.
For a Self-Employed Individual or Partner that is not compensated through payroll wages, when is the appropriate time to make a Solo 401k deferral election? At what time is their compensation available or unavailable to them? At which point is the compensation deemed available, such that it’s too late to make a deferral election?
- CFR 1.401(k)-1(a)(6)(iii) Rules applicable to cash or deferred arrangements of self-employed individuals provides that a partner’s compensation is deemed currently available on the last day of the partnership taxable year and a sole proprietor’s compensation is deemed currently available on the last day of the individual’s taxable year. Accordingly, self-employed individuals, including sole proprietors and partners, may not make a cash or deferred election with respect to compensation for a partnership or sole proprietorship taxable year after the last day of that year. In other words, Solo 401k deferral elections for proprietors and partners must be made by 12/31.
Solo 401(k) Contribution Questions & Answers
Solo 401k Employee Elective Deferrals Q&A
What are the limits that apply to Employee Elective Deferral Contributions to a Solo 401k Plan?
- Retirement plan limits are periodically adjusted for inflation. The most recent updates for 401k and IRA contributions, as of the writing of this post, were published in IRS Notice 2018-83 and are available on the IRS website, as well.
- The limitation, under IRC Section 402(g)(1), on the exclusion from taxable income for Solo 401k employee elective deferrals described in Section 402(g)(3) is $18,500 for the 2018 Tax Year. For 2019, the limitation is increased from $18,500 to $19,000.
- The dollar limitation under § 414(v)(2)(B)(i) for Solo 401k catch-up contributions to an applicable employer plan for individuals aged 50 or over remains unchanged at $6,000.
Can catch-up contributions be Roth type, or must they be pre-tax deductible contributions?
- As a form 401k employee elective deferral, which can be either tax-deductible or Designated Roth, catch-up contributions can take either form.
Solo 401k Employer Discretionary Profit Sharing Contributions Q&A
What are the limits that apply to Employer discretionary or non-elective contributions to a Solo 401k Plan?
- The maximum tax-deductible Solo 401k Employer Non-Elective Contribution is 25% of employee compensation, as defined by the plan. IRC Section 404(a)(3)(A). The actual profit sharing percentage may be any amount between 0% and 25% of employee compensation.
Is there a limit to the amount of employee compensation that can be taken in to account when calculating the tax-deductible limits for Employer Profit Sharing Contributions? If employee compensation is $400,000, could the employer selected profit-sharing percentage be applied to that amount to calculate the maximum tax-deductible employer contribution?
- IRC 401(a)(17) imposes limits on the amount of annual compensation of each employee taken into account under the plan for retirement plan calculations. For 2019, the annual compensation limit under Section 401(a)(17) is increased from $275,000 to $280,000.
Overall Solo 401(k) Plan Per-Participant Contribution Limits Q&A
There are 2 overall contribution limitations that apply to Solo 401k Plan Contributions, on a per-participant basis: (1) A flat-dollar cap and (b) the participant compensation cap. The overall annual additions to any Solo 401k participant’s account may not exceed the lesser of the 2 limits.
Are there overall limits that apply to Solo 401k plan contributions, regardless of their sources, employee elective deferral or employer non-elective contributions?
- IRC Section 415(c)(1)(A) provides for an overall flat-dollar limitation on annual additions to a 401k plan participant’s account from employee contributions and employer contributions. This amount is subject to cost-of-living adjustments and changes periodically. The limitation for defined contribution plans under IRC 415(c)(1)(A) is increased in 2019 from $55,000 to $56,000.
- IRC Section 415(c)(1)(B) provides for an overall limit based on Solo 401k Plan participant compensation. Contributions and other additions with respect to a participant may not exceed 100% of the participant’s compensation. In other words, combined contributions – employee elective deferrals and employer profit-sharing contributions – on behalf of a plan participant may not exceed that participant’s compensation from the employer.
- The overall limit on annual additions to a Solo 401k participant’s account is the lesser of the two foregoing limits.
Do Solo 401k rollover contributions count towards the IRC 415(c)(1)(A) overall limit on contributions and other additions?
- IRC 415(c)(2) explicitly excludes rollover contributions from being treated as annual additions for purposes of calculating overall contribution limits. Therefore, Solo 401k rollover contributions don’t reduce your ability to make tax-deductible contributions to your plan.
Do repayments of Solo 401k Participant Loan principal or interest count towards the IRC 415(c)(1)(A) overall limit on contributions and other additions?
- 26 CFR 1.415(c)-1 – Limitations for defined contribution plans provides that the term “annual addition” does not include repayments of loans made to a participant from the plan. Therefore, loan payments that you make to your Solo 401k plan don’t reduce your ability to make tax-deductible contributions to your plan.
How do the IRC 415(c)(1)(A) overall Solo 401k contribution limits impact the ability make catch-up contributions?
- IRC 414(v), which provides for Catch-up contributions for individuals age 50 or over, explicitly states that such contributions are not subject to the 415(c) limitations. Therefore, catch-up contributions can be made above and beyond those limits.
- The dollar limitation under IRC Section 414(v)(2)(B)(i) for catch-up contributions to an applicable employer plan for individuals aged 50 or over remains unchanged at $6,000.
- For 2018, those eligible for catch-up contributions may contribute up to $61,000 to a Solo 401k Plan, which is the sum of (1) the 2018 $55,000 415(c) limit and (2) the $6,000 414(v) catch-up contribution limits.
- For 2019, those eligible for catch-up contributions may contribute up to $62,000 to a Solo 401k Plan, which is the sum of (1) the $56,000 415(c) limit and (2) the $6,000 414(v) catch-up contribution limits.
How do Employee Elective Deferral Contributions impact the IRC Section 415(c)(1)(B) overall limitation based on 100% of participant compensation? Does the Employee Elective Deferral, which results in a reduction of compensation for income tax purposes, lower a participant’s compensation for purposes of calculating the 415(c)(1)(B) overall limit?
- Per IRC 415(c)(3)(D) The term “participant’s compensation” shall include any employee elective deferral (as defined in IRC Section 402(g)(3)). Therefore, making Employee Solo 401k Contributions does not adversely impact the overall tax-deductible limit.
Solo 401k Contribution Limits Based on Adopting Entity Tax Classification
Solo 401k Plans can be adopted by: Sole Proprietorships, Disregarded Entity Single-Member LLCs, Partnerships, Multi-Member LLCs taxed as partnerships, C-Corps, and S-Corps. Under the Check-the-Box Regulations, entities such as LLCs and Corporations, have the flexibility to elect from among available tax classifications.
Solo 401k Contribution Calculations for C-Corps and S-Corps
For Solo 401k plans that are adopted by entities taxed as either an S-Corp or C-Corp, the definition of compensation for all retirement plan calculations is: W-2 Compensation. S-Corp pass-thru income is NOT compensation and is not taken into account for retirement account contribution calculations.
- For S-Corps and C-Corps, Solo 401k Employee Elective Deferral Contributions can be made only from W-2 wages paid to the owner. Solo 401k Employee Elective Deferrals can’t be made from S-Corp pass-through income (“distributions”).
- Solo 401k Employer tax-deductible profit-sharing contributions can be made up to 25% of owners’ W-2 wages. The pass-through income to an S-Corp shareholder is NOT included in this calculation, either.
- The Overall Solo 401k Annual Additions limits are, likewise, based on owner W-2 compensation.
- Paying an S-Corp owner less than a “reasonable salary” will decrease payroll tax liability, but reduce valuable income tax deductions available through Solo 401k tax-deductible retirement plan contributions.
- When all applicable factors are considered, it becomes apparent that S-Corp elections advocated for by many advisors have many unintended and unfavorable consequences – within certain income ranges:
- Loss of SEP-IRA, Solo 401k, and Defined Benefit plan income tax deductions.
- Loss of tax-free compounding of investment income within tax-sheltered accounts.
- Reduction of IRC Section 199A 20% Qualified Business Income – QBI – income tax deduction. The QBI deduction is impacted in 2 ways: (a) The portion of income that is received by the S-Corp owner as a reasonable salary is NOT eligible for the 20% deduction, but would have been eligible for the deduction had it been received as self-employment income; (b) employer profit-sharing contributions by an S-Corp result in a reduction of QBI.
- Increased compliance costs associated with S-Corp bookkeeping, S-Corp income tax filings, S-Corp payroll calculations and filings.
- Increased risk of audit, interest, and penalties based on S-Corp owner salary being less than “reasonable.”
- Reduction of Social Security Benefits, which are based on prior earnings subject to Social Security taxes (FICA taxes). The purpose of using an S-corp is to minimize earnings that are subject to employment taxes, directly reducing your average indexed monthly earnings for Social Security purposes.
- The prior factors, when viewed collectively, make it clear that the S-Corp strategy requires much greater analysis than its advocates are aware of.
Solo 401k Contribution Calculations for Sole Proprietors and Disregarded Single-Member LLCs
The basic language used in the tax code to describe 401k operations – employer, employee, compensation – are suited to corporate entities. How do these rules apply to self-employed individuals, such as Sole Proprietors and Disregarded Entities? How do they apply to partnerships and multi-member LLCs taxed as partnerships?
IRC 401(c) expands the definitions of terms to include Self-Employed Individuals and Owner-Employees of unincorporated trades or businesses. Similar language is found in IRC 402(i). IRC 404(a)(8), in conjunction with IRC 401(c) expand the definition of compensation, as applicable to self-employed individuals.
You must make a special computation to figure the maximum amount of elective deferrals and non-elective contributions you can make for self-employed individuals, including partners. When figuring the contribution, compensation is your “earned income,” which is defined as net earnings from self-employment after deducting both:
- One-half of your self-employment tax, and
- Contributions for yourself.
Solo 401k Contribution Calculations for Partnerships and Multi-Member LLCs Taxed as Partnerships
A partner’s compensation for Solo 401 contribution calculations (IRC 401(c), 401(d), 1402(a)) include:
- A partner’s distributive share of partnership income or loss (other than separately stated items, such as capital gains and losses)
- Guaranteed payments to limited partners are net earnings from self-employment if they are paid for services to or for the partnership.
A Checkbook Solo 401k with total control is a powerful tax and investing tool for investing in real estate, private loans, ETFs, mutual funds, precious metals and coins, cryptocurrency, crowdfunded investments, litigation finance (lit-fin), merchant cash advance (MCA), cannabis & marijuana, private companies, tax certificates (liens & deeds), life settlements, and nearly any other investment that you choose.
A Solo 401k is the most effective, flexible, and efficient tax-mitigation strategy available for qualifying businesses. Optimizing your Solo 401k tax strategy requires a solid grasp of Solo 401k Contribution calculations. Access our Solo 401k Contribution Calculator by clicking here.