Solo 401K question

[shayanbruin]

Hi,

My husband is a sole proprietor and has an S Corp for his business. He took a salary of $36,000 with the rest of the income as distributions. We contributed $19,500 as an employee contribution this year to his Solo 401K (he is under 50). Am I correct that 25% of the "salary" of $36,000 is the allowed employer contribution ($9,000)?

Also I read on a blog post that you can make the employee contributions ROTH contributions. How do you do that? And why would that make sense (as opposed to pre-tax) when we are in our peak earnings years (not him per say but me at close to $900,000 and we file jointly).

Thanks.

[childay]

Hi,

My husband is a sole proprietor and has an S Corp for his business. He took a salary of $36,000 with the rest of the income as distributions. We contributed $19,500 as an employee contribution this year to his Solo 401K (he is under 50). Am I correct that 25% of the "salary" of $36,000 is the allowed employer contribution ($9,000)?

Also I read on a blog post that you can make the employee contributions ROTH contributions. How do you do that? And why would that make sense (as opposed to pre-tax) when we are in our peak earnings years (not him per say but me at close to $900,000 and we file jointly).

Thanks.

How much income does he make in total?

[DAK]

To clarify, you can be a sole proprietor OR a S-corp. But not both. (Unless you formed the company during the tax year or are referring to two separate businesses).

You can do that if the plan documents allow it. Various free plans will allow it. You either contribute directly to roth or you contribute to pre-tax and then convert to roth. The mechanism depends on the plan documents and the custodian.

what childay is hinting at is that you need to pay "reasonable compensation" as wages. Without more information on your business we can only guess. But because most people on this forum are higher income, the assumption is that he makes 150k+ in profit from the business. At that rate, you'd have a hard time justifying only $36k in salary, especially if for a skilled profession and the general impression is that creates a red flag for an audit. There may be a good reason, but usually it involves multiple additional employees, in which case a solo 401k is not an option.

[shayanbruin]

My error. He is has an S Corp (not a sole proprietor). Also he is not a high earner in the MD range. Net business income in 2020 was 45k.

[jacoavlu]

yes for S corp profit sharing can be up to 25% of compensation

you are a high earner, are you an owner in a business / practice?

[DAK]

Given your income, it is highly likely that the best joint bet is for him to make pre-tax EmployEE contributions. EmployER contributions have to be pre-tax.

Etrade has a free solo401k and I believe the free option includes the option for roth contributions and in-plan conversions of employee contributions (and their growth). The way it works in practice is that you open a 401k with them with two sub-accounts: a pre-tax account and a roth account. This makes keeping track of contributions and their growth, etc. easier.

[spiritrider]

Why was an S-Corp created in the first place with such a minimal gross business profit (ex. payroll costs)?

Nominal net business profit will be <= gross business profit ($45K) - compensation ($36K) - FICA employer share ($36K * 7.65% = $2754) - minimum unemployment insurance ($420) = $5826. The S-Corp's total payroll taxes = ($36K * 15.3% = $5508) + 420 = $5928.

A self-employed individual with $45K in net business profit would pay $45K * 92.35% ~= $6358. The S-Corp would only save a maximum of ~$6358 - $5928 = ~$430 in FICA taxes over a sole proprietor. That is before any incorporation fees, annual fees and taxes, payroll and accounting costs and the general hassle factor.

Not to mention, while this S-Corp 2% shareholder employee can receive maximum employer contributions = $36K * 25% = $9K. This S-Corp only will have $5826 available to contribute unless there already is basis, an investment or loan is made to the S-Corp prior to year end.

Why a sole proprietor could receive employer contributions of $45K - 1/2 SE Tax ($6358 / 2 = $3179) = $41,821 * 20% = $8364.

Absent some compelling reason the S-Corp was ill-advised.

[jacoavlu]

Why was an S-Corp created in the first place with such a minimal gross business profit (ex. payroll costs)?

most likely because a CPA advised such