Confused By 415 Limit On The Solo 401K Plan

[bookcar]

Case 1)

Suppose I am a sole proprietor w/o common-law employees, with a net business profit of $10000. And this is my only self-employment income. I have no other employee contribution in any other retirement plans. Half of the SE tax on $10000 is $706. What is the maximum amount $X I could contribute to my solo 401K thru self-employment employee pretax deferral?

Reading through the Code, I see the constraint is that my employee deferral must not exceed my self-employment "plan compensation", defined as $10000-$706 minus the amount on Line 15 of Sch 1 (the self-employment retirement deduction $X). So the 415 limit here is simply $X <= $10000-$706-$X. In other words, $X <= ($10000-$706)/2 = $4647.

Is this correct pretax contribution limit? If I do employee Roth (or aftertax) contribution, it seems that I could do $10000-$706, as nothing shows up on Line 15 Sch 1. Is this correct?

Case 2)

Same as Case 1), except that I am now the owner-employee of a S-Corp. My Box-5 W2 salary is $10000.

Could I contribute $10000 as pretax employee deferral to my solo 401K? (This would make the W2 Box-1 all the way to zero?)

What bothers me in this situation is that, after employee deferral, the payroll service provider won't have any money left in my paycheck to deduct the employee part of the FICA tax. Could I send in money to the payroll service provider (as I am basically getting a negative net take home pay for each paycheck) in order to defer the entire $10000?

Thanks so much for your help.

[spiritrider]

Case 1

• Form 1040, Schedule 1, Line 15 is the 1/2 SE tax deduction. It is only subtracted once.
• Self-employed earned income (net earnings from self-employment) = business profit (Form 1040, Schedule 1, Line 3) - 1/2 SE tax (Line 15).
• Form 1040, Schedule SE is used to calculate SE and 1/2 SE tax. The latter would only be $10,000 * 92.35% * 15.3% / 2 = $706, if other W-2 Box 3 Social Security (SS) wages + ($10,000 * 92.35%) is < the SS maximum taxable earnings (MTE) (2021 = $142,800, 2022 = $147,000). Otherwise, it could be much lower.

Case 2

• Employee deferrals can only be deducted from compensation after all mandatory deductions. These include FICA taxes, unemployment insurance (UI), any other state payroll taxes, any federal/state/local income tax withholding, etc...
• The maximum W-2 wages and employee deferrals = $10,000 - $765 FICA - $420 federal UI - any additional state UI amount and/or payroll taxes - any federal/state/local income tax withholding, etc..
• Not to mention, you should almost never create an S-Corp with such low net profits or if your other W-2 Box 5 SS wages are >= the SS MTE.

All payroll costs including employee deferrals must come from S-Corp accounts.

[bookcar]

Thanks so much, for your quick reply. This is really a hypothetical exercise to understand the Code in the edge cases.

For Case 1)

I mis-spoke earlier. It should have been line 16 "Self-employed SEP, SIMPLE, and qualified plans" (tax year 2021). Sorry about that error.

So my question remains. "What is the maximum amount $X I could contribute to my solo 401K thru self-employment employee pretax deferral?" (Further assume that I incur the full SE taxes on this income, half of which being $706).

Per https://www.irs.gov/retirement-plans...-and-deduction

"However, you must make adjustments to your net earnings from self-employment to arrive at the amount of "plan compensation" to use to determine the plan contribution/deduction for yourself.

Plan compensation for a self-employed individual:

To calculate your plan compensation, you reduce your net earnings from self-employment by:

• the deductible portion of your SE tax from your Form 1040 return, Schedule 1, on the line for deductible part of self-employment tax, and
• the amount of your own (not your employees’) retirement plan contribution from your Form 1040 return, Schedule 1, on the line for self-employed SEP, SIMPLE, and qualified plans."

So my understanding is, if I defer $X pre-tax, then my "Plan Compensation" also goes down by $X. Hence, I could at most defer half of $10000-$706. Is this correct?


For Case 2)

[You mentioned something extra --- do not use a S-Corp if your day-job W-5 Box 5 already exceeds SS MTE. This is a good point. My understanding of your reasoning is that one would end up with excess social security tax withheld. Tax-payer only gets back the employee half of the excess (as a F1040 credit), but the employer half of the excess is lost.]

But the above is separate point. Back to my original question where S-Corp has a gross receipt of say $15000, and pays $10000 in Officer's Compensation.

Can the officer, through W-4, elect zero withholding for Fed/State income tax, and pre-tax defer $X to his Solo-401K. What's the maximum value possible for $X, $10000, or $10000-$704, or something else? (S-Corp will pay UI, employer share of FICA, etc. out of the corporate account, nothing to do with the officer.)

[spiritrider]

Self-employment:

That is unfortunate wording from the IRS. Only employer contributions reduce plan compensation and not employee deferrals

Maximum of only employee deferrals with $10,000 business profit - $706 1/2 SE tax = $9,394.

If you were to make $9,394 * 20% = $1879 in employer contributions. The employer contribution would reduce your compensation $9,394 - $1,879 = $7,515 and also reduce the amount available for employee deferrals - $1,879 = $5,636.

However, any pre-tax employee and/or employer contributions will reduce any self-employed health insurance deduction.

If you are eligible for the QBI deduction, any pre-tax employee and/or employer contributions will reduce the qualified business income (QBI) available to claim the deduction.

This information is all contained in Schedule C/SE instructions and Publication 560.
S-Corp:

As long as an S-Corp has sufficient profits to cover all payroll costs, taxes, employer contributions. 100% of an S-Corp's 2% shareholder-employee's net wages are available for employee deferrals up to the employee deferral limit. At the same level of net profits, an S-Corp's 2% shareholder-employee's contributions will always be < a self-employed individual's.

As I pointed out earlier an S-Corp is seldom advantageous for moonlighting income of a White Coat. Also, it is seldom advantageous for sole income if eligible for the QBI deduction.

[bookcar]

Thanks spiritrider I saw a few other replies from you on some other posts. You seem very knowledgeable. Thank you for sharing your expertise. I am much obliged. (That IRS wording confused the heck out of me!)

Just for a last clarification, S-Corp "2% shareholder-employee's net wages" in my example would be = gross wage (box5) - employee share of FICA = $10,000 - $706 = $9394?

And the reason that "At the same level of net profits, an S-Corp's 2% shareholder-employee's contributions will always be < a self-employed individual's" is due to 1) the extra costs like UI, and 2) the employer share of FICA of S-Corp must be covered by the gross revenue (while the self-employed could do so using his other personal funds), assuming we don't want to have a S-Corp net loss?

My understanding of the main advantage of S-Corp is the so-called "Gingrich-Edwards" method of only paying "reasonable" officer comp with the rest being outside of FICA taxation. I also thought S-Corp is better at getting the QBI deduction (when income is high) as S-Corp might have enough W2 wages.

Again, many thanks!

[CordMcNally]

Thanks spiritrider I saw a few other replies from you on some other posts. You seem very knowledgeable.

Frontrunner for understatement of the year.

[Hank]

Frontrunner for understatement of the year.

It's early April, but "yup".

[bookcar]

Sorry. I am new to this Forum. Getting to know various guys!

[Hank]

Sorry. I am new to this Forum. Getting to know various guys!

No worries. A big part of this forum is to impart and transfer financial wisdom. Spiritrider does an outsized job of accomplishing that mission.

[bookcar]

I know a few things in other sub-domains of finance. Look forward to sharing! Thanks, everyone.

[spiritrider]

bookcar it would be more helpful if you provided your specific facts and circumstances. Specifically, other W-2 wages, filing status, actual/projected business profits, total income.

It is very dangerous to attempt to use rules of thumb. You need to use the complete rules and procedures. As I previously outlined, they are in Form 1040 Schedule C/SE and Publication 560.

The Qualified Business Income (QBI) used in calculating the QBI deduction.

Self-employment QBI:

• Business profit less
  • 1/2 SE tax
  • any Self-employed health insurance deduction
  • pre-tax (employee + employer) retirement plan contributions

S-Corp 2% shareholder-employee QBI:

• W-2 Box 1 wages less
  • any Self-employed health insurance deduction

With the same business profit, an S-Corp will always have a smaller QBI deduction than as a self-employed individual. Since a significant rational for an S-Corp is to avoid FICA taxes on distributions. That also results in no QBI income on those distributions.

[bookcar]

spiritrider Sorry for the late reply, I didn't see you answer until now.

The reason I seemed vague is that I need to fully understand the tax code, and then code up the logic in my Excel workbook, in order to run optimization. So it's a chicken and egg situation, I need to know the logic first, then I would know how to structure everything, and then finally I would have specific numbers.

I really appreciate your help.