Sole Proprietor Deduction Limit

[Guest Aliactuary]

I know that the DB deduction limit for a sole prop is 100% of earned income less SE tax. Is this merely in a private letter ruling, or has it bene codified? Client is asking me for the citing.

Also, does this apply just to the DB deduction, or to deductions for all plans? For example, if 100% of earned income less 1/2 SE tax is $200K, and DB contribution is $190K, can client ad another $20K 401k, or is he limited to $10K?

[mwyatt]

As to your 401k question, I'd use common sense (of course that may completely be the wrong approach with tax law) and compare the same situation to your client if he was incorporated. Your Net Earned Income is $10k, as would be salary if he was incorporated. 415 would limit the deferral to $10k.

And to clarify, I think what you are asking is Line 31 Sch C less SET deduction equals $200k, DB cbn of $190k, so Net Earned Income (the analogy to compensation) of $10k for your example.

[SoCalActuary]

Start with IRC 401©.

[mwyatt]

Looking again at your question, are you asking whether DB cbn can't exceed net earned income (certainly it can), or whether you mean DB cbn exceeds Schedule C Income (which is something different entirely). Assume you are focusing on DB cbn producing negative Net Earned Income. Clarification?

[Lame Duck]

You might also take a look at 404(a)(8).

[Draper55]

I do not believe the total deductions can exceed earned income per IRC 404(a)(8). Whether it comes from one plan or four is irrelevant. Excess contributions may be subject to the excise tax per IRC 4972.

[mwyatt]

Let's clarify this "earned income" which is being bandied about here, since we have two components that both use these words. If you mean Line 31 Schedule C Income, then the contribution can't exceed this amount. However, if you mean Net Earned Income (which equals Schedule C Income less SET deduction less plan contribution), then contribution could certainly exceed the Net Earned Income.

[SoCalActuary]

If you are only working with a DC plan, the limit of contribution to earned income after deductions might apply.

Then the 100% of pay 415 limit would apply giving a result of 50% of net SE income after SE taxes.

However, this presumes that 401(k) deferrals are a substantial part of the total earned income. Otherwise, the 25% of pay deduction would limit the contribution to effectively 20% of net SE income after SE taxes.

You should look at the deduction worksheet in the appendix of IRS Pub 560, which sets out the deductions for a DC plan of a self-employed person.

[Mike Preston]

It is wrong to define net SE income as some number reduced by 401(k) deferrals. Hence, the 50% figure is a misconception.

Net SE income is subject to FICA taxes.

Isn't our nomenclature confusing enough without modifying definitions on the fly?