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Solo k for Sole Proprietor - Computation of Contributions for Proprietor Based on Earned Income


rocknrolls2
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The IRS recently issued a TE/GE Issue Snapshot entitled "Calculation of Plan Compensation for Sole Proprietorships."  This Issue Snapshot involved the calculation of earned income with respect to nonelective contributions to a defined contribution plan in the situation where the self-employed individual has made no elective deferrals and the nonelective contribution is fully deductible under Section 404. 

My question is, assuming that the proprietor's net income from self-employment is equal to $100,000 for 2021 and s/he has established a solo 401(k) for 2021, how do you calculate the elective deferrals? I know that for the common law employee, elective deferrals are subject to FICA withholding. By extension to the self-employed individual, I would assume that the elective deferral would also be subject to the self-employment tax on earned income. If that is the case, do you simply multiply the earned income amount by the 0.9235 (which is the amount you would multiply self-employment income to arrive at the amount which is subject to self-employment tax and then multiply that by 15.3%, leaving the balance as potentially available elective deferrals?

I would appreciate anyone's thoughts on this issue.

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As Bird said, what is the election?

But for a Sole-Prop you are probably going to have a net income on Line 31 of Schedule C which is what it generally going to go on Form SE for calculating the SE tax half of which is deductible as the Employer portion, I believe all contributions on behalf of the Proprietor are then deducted on Schedule 1 Line 15. The portion of the contribution that is Employer contribution will reduce the Proprietor's income for pensions, the portion that is elective 401(k) deferral will not. But I'd always suggest double checking with the CPA.

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Bird and Lou S.,

Thank you for your responses. At the least, I owe you an answer to  Bird's question. At this point, I am simply trying to establish what is potentially available to elect as an elective deferral, from $0 to the 402(g) limit. That's all. Then the solo will elect and contribute an amount somewhere in between the two.

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I have edited this post to take into account the corrections pointed out by others, below.

mike

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The confusion is due to the lack of standardized language.  The OP refers to something being equal to $100,000.  This something is described as "net income from self-employment".  I have a suspicion the OP means "Net profit as shown on the Schedule C".  With "Net profit as shown on the Schedule C" of $100,000 then the technical definition of "net income from self-employment" is $92,350 ($100,000 * .9235). If so, then the $92,350 goes into the calculation of the FICA tax adjustment but otherwise is ignored for all plan calcs.  With $92,350 as the starting point, the FICA tax adjustment is $7,065.  Subtracting $7,065 from the net profit leaves you with $92,935 as your starting point for all of the plan calcs you need to do (415 limit and maximum deductible).

So we have two numbers that are very similar ($92,350 and $92,935) which leads to confusion.  

With $92,935 as your starting point for plan calcs you will find that the employer contribution is limited to $18,587 [not $15,489 as originally stated in this post] at the high end and, of course, $0 at the low end.  You can't really calculate the salary deferral until you have decided on the employer contribution.  But we know that the maximum salary deferral is $19,500 no matter what the employer contribution ends up being (somewhere between $0 and $18,587 [not $15,489 as originally stated in this post]).

As a double check you can state your results based on the maximum employer contribution of $18,587 [not $15,489 as originally stated in this post] and maximum salary deferral of $19,500:

Employer contribution: $18,587 [not $15,489 as originally stated in this post]

Salary deferral: $19,500

Plan Compensation: $74,348 [not $77,446 as originally stated in this post] ($92,935 - $18,587 [not $15,489 as originally stated in this post])

Maximum annual additions: $58,000 (lesser of $74,348 [not $77,446 as originally stated in this post] [100% of comp] and $ limit of $58,000)

Actual annual additions: $38,087 [not $34,989 as originally stated in this post] ($18,587 [not $15,489 as originally stated in this post] + $19,500)

Maximum deductible employer contributions:  $18,587 [not $15,489 as originally stated in this post] ($74,348 [not $77,446 as originally stated in this post] * 0.25 [not .2 as originally stated in this post])

Actual employer contributions: $18,587 [not $15,489 as originally stated in this post]

So the determination of the actual salary deferral revolves around the employer contributions for the year.  With employer contributions totaling $18,587 [not $15,489 as originally stated in this post] you have plan compensation of $74,348 [not $77,446 as originally stated in this post] and your salary deferrals for the year are $19,500 assuming a percentage election is 26.23% [not 25.2% as originally stated in this post] or more.  With employer contributions totaling $0 you have plan compensation of $92,935 and your salary deferrals for the year are $19,500 assuming a percentage election is 21% or more.  

 

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Mike laid it out very well.

A few minor correction though is that the Maximum Annual addition is the lessor of 100% of Compensation of the 415(c) dollar limit for the year, which for 2021 is $58,000.

I get a maximum deductible employer contribution that would be 20% of $92,935 or 25% of 73,880 = $18,470.

Also if the participant is age 50 or older the elective deferral could be $6,500 higher with the catch-up. The catch-up is also not subject to any plan limitation including the 415 limitation.

 

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27 minutes ago, Lou S. said:

Mike laid it out very well.

A few minor correction though is that the Maximum Annual addition is the lessor of 100% of Compensation of the 415(c) dollar limit for the year, which for 2021 is $58,000.

I get a maximum deductible employer contribution that would be 20% of $92,935 or 25% of 73,880 = $18,470.

Also if the participant is age 50 or older the elective deferral could be $6,500 higher with the catch-up. The catch-up is also not subject to any plan limitation including the 415 limitation.

 

I made the $ limit change that you pointed out.  I think your 20% of $92,935 is correct only if the actual contribution is $0.

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50 minutes ago, Mike Preston said:

I made the $ limit change that you pointed out.  I think your 20% of $92,935 is correct only if the actual contribution is $0.

Why? If you reduce the $92,935 by the $18,587, 20% of gross, then you are left with a net comp of 74,348 which if you take 25% of the Net comp you get the same $18,587 of 25% of eligible compensation. No?

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16 minutes ago, Lou S. said:

Why? If you reduce the $92,935 by the $18,587, 20% of gross, then you are left with a net comp of 74,348 which if you take 25% of the Net comp you get the same $18,587 of 25% of eligible compensation. No?

No. You must reduce the higher number by the actual contribution before multiplying by 20%.

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Thank you everyone for your responses! There are so many numbers and permutations, that it is making my head spin. Apart from that, I happened to look at IRS Publication 560. On page 24, there is an excellent worksheet for the self-employed, which includes elective deferrals and catch-up contributions. This substantially makes things much clearer and really puts them into perspective.

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I agree with Lou S. on the calculation of the maximum deductible employer contribution. While I agree with the portion of Bird's statement that you have to subtract any employer contribution to get the net compensation available for deferrals, I don't agree that Mike Preston has the correct maximum employer contribution. Mike indicates that you subtract the employer contribution (and 1/2 of SE tax) and then multiply the result by 20%. I think that you multiply the result by 25% if you have already subtracted the employer contribution and 20% if you have not. I always learned it as 20% of gross equals 25% of net but just two different ways of getting to the same correct answer:

$100,000 - $7,065 = $92,935 * 20% = $18,587

$100,000 - $7,065 - $18,587 = $74,348 * 25% = $18,587

Admittedly, I've followed these boards enough to know the both Mike Preston and Bird are way smarter than me! So, to make sure I wasn't losing it completely, I even plugged $100,000 of schedule C income into Datair and requested a 25% of pay profit sharing allocation. It calculated $18,587 also.

 

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