2002 401k for self employed

[dmb]

If a Self Employed person has a 401k plan and earns net income of $15,000 for 2002 and defers $11,000, would a profit sharing contribution be based on the $15,000 comp or would it be based on $4,000 comp?? Since the salary deferrals are not part of the 25% of comp deductible limit do i have to consider them for the comp used to calculate the profit sharing contribution?? Thanks.

[stephen]

It is my understanding that you could do the following:

$3,000 profit sharing contribution

$1,000 catch-up contribution (if you are over 50 or will turn 50 this year)

$11,000 salary deferral

Total contribution $15,000

If you are not eligble for the catch up contribution your profit sharing amount could be increased by $3,750 (25% of 15,000).

[dmb]

So even though the deferrals are contributions they don't reduce compensation for profit sharing contribution purposes for a self employed particpant???

[Guest Chamelnix]

I agree that the deferrals would not reduce earned income for purposes of determining the maximum profit sharing deduction, but the profit sharing contribution itself would still reduce earned income.

If an individual's bottom line schedule C minus 1/2 SE Tax is $15,000 and the profit sharing contribution is $3,000, then the compensation for plan purposes is only $12,000. In isolation, the $3,000 could be deducted as it is 25% of pay, but if you also try to defer $11,000, you will violate the 415 limit of 100% of pay.

[Appleby]

Stephen,

The $3,750 applies whether or not the catch up contribution is made. The profit sharing contribution would be based on the $15,000, therefore the total contribution would be:

$11,000 salary deferral

$3,000 profit sharing contribution

$1,000 catch-up contribution (if you are 50 by the end of the year)

dmd,

You state this is a self-employer person. Is the $15,000 the business owner's net profit or Adjusted Net Business Income (ANBI)? If it’s net profit , you need to determine the ANBI , as it is the amount on which the percentage of employer contribution will be based- and this would mean that the contribution amount would be less than the amount stated above.

[dmb]

Something still doesn't make sense to me.

Let's work with more realistic numbers. If a sole-prop, over age 50, has $40,000 in net Sked C income after Self Employment Tax Deduction you're saying that they can defer $12,000 and still contribute 25% of the $40,000 as a profit sharing contribution. That doesn't sound right. Even if the $40,000 has to be split among contribution and benefit compensation, for example, $8,000 ps contr and $32,000 benefit comp., from a tax standpoint it doesn't make sense. Even though the 401k deferrals don't cound against the deductible limit, in order for the Sked C to flow, the deferral would have to be counted against the Sked C comp.

Am i making sense??

[R. Butler]

See EGTRRA §616. In your example he could get a profit sharing of $8,000 and still defer the maximum.

Why does this matter for the Schedule C?

[jpod]

In the example involving $15,000 of net income (after the self-employment tax deduction), I believe the answer is as follows:

Regular elective $11,000

Catch-up $ 1,000

Profit Sharing $ 2,000

Total $14,000

415© compensation here is $13,000 [$15,000 - $2,000]. The sum of the regular elective contribution and the profit sharing contribution is $13,000, and the catch-up is a free-bee, so we're ok under 415.

On the deduction side, you have to do the algebra so that the net earned income is further reduced by the profit sharing contribution (but not the regular elective contribution or the catch-up). So, the deduction limit is 25% x [$15,000 - $2,000] = $3,250, but that is trumped by the 415 limit.

[Appleby]

For a Sole proprietor with a net income of $15,000, the maximum contribution is determined as follows.

ANBI= Net income-(1/2 of S/E tax)

ANBI= $15,000-1162.5

ANBI =13,837.5

Maximum Salary deferral = $11,000 ( the lesser of $11,000 or ANBI)

Maximum Profit sharing contribution = ANBI x 20% *

Maximum Profit sharing contribution = 13,837.5 x 20%=2,767.50

Maximum contribution =

11,000

+ 2,767.50

_________

13,767.50 Total Plus catch up contribution , if age 50 or older by year end

* For a sole proprietor, the deductible limit is 20%, not 25

[Appleby]

I just noticed that the question assumes $15,000 is the ANBI.

The maximum contribution would then be

Maximum Salary deferral = $11,000 ( the lesser of $11,000 or ANBI)

Maximum Profit sharing contribution = ANBI x 20% *

Maximum Profit sharing contribution = 15,000 x 20%=3,000

Maximum contribution =

11,000

3,000

_________

14,000 Total ( as stated earlier) -Plus catch up contribution , if age 50 or older by year end

[jpod]

Appleby:

The example assumed that $15,000 was AFTER the deduction for 1/2 of the SE tax.

But, putting that point aside, in the case of a self-employed person, isn't the 415 limit ANBI minus the profit sharing contribution? i.e., the 415 limit is "earned income," and that means ANBI minus the Section 404 deduction.

[jpod]

Appleby:

In your revised example, if the profit sharing contribution is $3,000, then the 415 limit is $12,000 [$15,000 - $3,000]. 415 is the critical limitation in this situation. If the 415 limit is $12,000, and the profit sharing contribution is $3,000, that only leaves $9,000 for an elective deferral. I think we agree that the catch-up of $1,000 is a free-bee. So, if the profit sharing contribution is $3,000, the total put away is $13,000.

Ironically, as in my example, if the profit sharing is only $2,000, that leaves us with a 415 limit of $13,000, which leaves room for the full $11,000 elective deferral. That, plus the catch-up, gives us $14,000!!!

[Appleby]

I don’t think so. You math applies to the 404 limit. For the 415 limit, you would subtract contributions for common-law employees, , if any, and one-half of your self-employment tax from the net earnings. With the example of an ANBI of $15,000, the net earnings is approximately $16,250.00. Since there are no common-law employees in this example, all we subtract from the net earnings is 1.5 of the SE tax, leaving us with $15,000.

[jpod]

Appleby:

Please give me one more chance to explain, and tell me where you think I've gone wrong.

First, let's assume that Schedule C net income minus 1/2 of SE tax is $15,000. [For what it's worth, you need net Schedule C net income of $16,140 to reach this result, not $16,250.]

Second, I have assumed all along that this is a one-person plan covering only the self-employed person.

For a self-employed person, 415 comp. is "earned income" as defined in Section 401©(2). [415©(3)(B)]

Per 401©(2), "earned income," in our example, would be $15,000 reduced by the deductions allowed by Section 404. [401©(2)(A)(5)]

Per 404(n), elective deferrals are not subject to any 404 limitations. Per 414(v), catch-ups are not subject to any 404 or 415 limitations.

Therefore, the 415 limitation is "earned income," which in our example is $15,000 minus the profit sharing contribution. If the profit sharing contribution is $3,000, that leaves us with "earned income" of $12,000. To complete the circle, if earned income is $12,000, the 415 limit is $12,000, and if the profit sharing contribution is $3,000, that leaves only $9,000 for an elective deferral.

[Guest pjb]

I agree EGTRRA automatically adds deferrals back in for purposes of determining deduction limits, but isn't the question whether the definition of earned income as defined 401©(2) now includes deferrals for allocation purposes? 401©(2)(A)(v) requires us to reduce deductions permitted under 404. Salary deferrals are still deductible under 404. But, 414(s) allows us to include or exclude deferrals and still be safe harbor. So, isn't the answer dependent what the plan document provides?

[jpod]

I think that salary reduction contributions are still deductible under 404 by reason of the flush language at the beginning of subsection (a), but they are not subject to the profit sharing plan deduction limit (now, 25% of comp); and salary reduction contributions do not reduce "comp" for purposes of the deduction limit.

[Guest pjb]

If dmb is contributing a profit sharing allocation equal to a certain percentage of pay, then I was suggesting dmb double check the plan document because it could exclude the deferrals. My comment was just to clarify that adding or subtracting deferrals is still an option by plan design for allocation purposes and not necessarily automatic. Do you agree?