Sole Prop. sponsoring a 401(k) plan in 2002.

[Guest Joe Vasko]

If a sole prop. sponsors a 401(k) plan in 2002 and defers $11,000 of his/her earned income is the 25% deductibility limit for a PS contribution based on his/her adjusted earned income (after SE tax) which includes or does not include employee deferrals?

[Archimage]

You are confusing the 404 deduction limit with the 415 individual limit. The 415 limit is updated for 2002 to the lesser of 100% of compensation or $40,000. The company itself can now contribute 25% of total company compensation to a plan without including EE deferrals.

[Guest Joe Vasko]

I"m really not confusing the deductibility limit under code section 404 with the annual addition limits of code section 415. To re phrase my original question: The net earned income of a self employed individual is earned income (e.g. Schedule C) less the deduction for self-employment tax. Do employee deferrals have to be subtracted out of net earned income before calculating the 25% deductible employer contribution?

[Archimage]

I believe you would only deduct the half of the SE tax that would deal with the employer side. You would still have to include one half of the tax in gross income.

[Moe Howard]

Joe - Effective for years beginning after 12/31/01. the definition of "compensation for purposes of the deduction rules" has changed.

For Year 2002:

Your sole proprietor will NOT EXCLUDE the elective deferrals of his employees when he determines "aggregate compensation" on which to base his Sch C deduction. Nor will he exclude his own

elective deferral when he determines his own "aggregate compensation/ earnings" on which he will base his Keogh contribution.

The rule in year 2001, is that elective deferrals are excluded from eligible compensation.

[rocknrolls2]

I would agree with the others that the compensation is not reduced by the elective deferrals. However, to the extent of any "employer" contributions, the self-employed definition of earned income requires that the earned income be determined after the deduction for employer contributions. Thus you would look at Schedule C net income minus the one-half of SECA tax deduction times 20%.