Solo 401(k) & Max Profit Sharing Contribution

[ubermax]

For a solo 401(k) plan with no deferrals or match , I believe the following expression is correct for the determination of the maximum deductible profit sharing contribution :

Net Sch. C Profit - 1/2SETax - (.25)(Earned Income) = Earned Income  and so the max profit sharing contribution is 20% (i.e. 25/125 ) of (Net Sch. C Profit -1/2Se Tax ) .

Now , if there are deferrals and match , are they both , or only one , or neither subtracted from the left side of the equality shown above ?

Thanks , in advance , for any replies .

 

 

 

[Mike Preston]

Trick question, huh?  I think the answer is "neither". Basically, the term "(.25)(Earned Income)" represents the maximum employer contribution that can be made.  So, first thing, is that deferrals don't have any impact on the calculation.  Second thing, whatever happens to be a match is just a part of the employer contribution for the year.  Give a couple numerical examples to prove the theory.

[jpod]

Please explain why you would ever consider a match in a one-person plan? 

[spiritrider]

For the self-employed person and only the self-employed person, there is one situation in a 401k where employee deferrals can impact employer contributions.

Net self-employment income = Net business profit - 1/2 SE tax. Maximum employer contribution is normally = net self-employment income * 0.20.

However, if the employee deferral is > 60% of the net self-employment income, the maximum employer contribution is (net self-employment income - employee deferral) / 2. In 2017 this occurs when you take the maximum $18K deferral and your net self-employment income < $30K or $24K/$40K respectively if age >= 50.

See IRS Publication 560, Deduction Worksheet for Self-Employed, steps 11 - 13.

[Mike Preston]

I disagree with your specific formulas, but I agree the abbreviated formula breaks down when the sum of the deferrals (exclusive of catch-ups) plus ".25*(Earned Income)" exceeds the 415 limit, which for low Earned Income amounts is 100% of Earned Income.  Good catch.

[ubermax]

thanks everyone for your time and insights and I agree Jpod , the profit sharing alone captures the entire allowable .

[Mike Preston]

spiritrider asked me privately what part of the formula I disagree with? While I agree that the formula holds water when there are no catch-ups, I have a problem with the formula when there are catch-ups (which don't count for 415). I don't have time to determine how the formula should be changed when there are catch-ups.  Perhaps spiritrider can do that.

[PFranckowiak]

I think you can find a calculator on

http://www.401khelpcenter.com/401k/pension_online_solok_calculator.html#.WPi300uGOUk

I always check it for accuracy, but it gives you a start.

 

 

[spiritrider]

Please note any bolded edits. The previous version of this post was incomplete and in error when the deferral included catch-up amounts.

I hope this post is not too long or detailed for this forum, but it was suggested I post this here.

While the criteria of when the elective deferral > 60% of the net self-employment income causes the limitation in the employer contribution is not in any IRS document or calculation, it is the effective net result when no catch-up is used

In Pub 560, the Deduction Worksheet for Self-Employed , lines 8-13, the (net self-employment income - employer deferral) / 2 (not including any catch-up), is compared with the straight 20% calculation and with applying the 415c limit. The lowest of the three values is used.

My other way of looking at this is that the (net self-employment income - employer deferral) / 2 limitation will only apply when the net self-employment income - employer contribution reduction in compensation - employer contribution itself < employee deferral. This occurs when 100% - 20% - 20% = 60% < employee deferral. Therefore, this only occurs when the employee deferral > 60% the net self-employment income.

For example, with a net self-employment income of $30K and an employee deferral of $18K, the maximum calculated employer contribution is $6K. $18K + $6K = $24K < $54K and ($30K - $18K = $12K) / 2 = $6K. The employer contribution is not limited.

For example, with a net self-employment income of $25K and an employee deferral of $18K, the maximum calculated employer contribution is $5K, ($25K - $18K = $7K) / 2 = $3.5K. The employer contribution is limited from $6K to $3.5K

 

[spiritrider]

I would suggest caution when using solo 401k calculators on the web. This calculator as well as many others, do not properly handle the low income scenario I have outlined above. Vanguard's and Fidelity's caclulators do seem to handle this properly.

This will cause an excess employer contribution to a 401k and it can not simply be removed as an excess contribution. I was able to help someone get it removed as a mistake of fact, but I was rather surprised the trustee agreed. I wouldn't want to rely on that.

You really need either tax software or Schedule C, Schedule SE and the Deduction Worksheet for Self-Employed. This will take care of the scenario I have been talking about or when the self-employment is moonlighting income in addition to W-2 employment and the SS max wage base gets exceeded.

Of course, even the tax software can not handle the case with 403b aggregation.

Personally, I like the spreadsheet Solo 401k For Part-Time Self-Employment spreadsheet on the The Finance Buff's website. While I can not 100% vouch for it, I have tried many scenarios and it answered them correctly The thing here is not only does he handle the low income scenario and the moonlighting scenario, but he also handles 403b aggregation.

Remember trust but verify. Excess employee deferrals are easily removed, but excess employer contributions are a mess you don't need

[Mike Preston]

So, how does your formula work with net self-employment = 20k; deferrals of 18500?  Doesn't the formula say $750? Will anything between $751 and $1,000 be a problem?

[spiritrider]

Now, I understand what you meant about the formula. I just ran those numbers through the 560 worksheet. The answer is $1,000. An even more interesting result is with $30K in net self-employment income and a $24K deferral including the full catch-up, you can still make the full employer contribution of $6K.

I will edit my post that the correct formula from the steps 11&12 of the worksheet is (net self-employment income - employee deferral) / 2. Not including any catch-up.

I always knew the catch-up did not apply to 415c dollar limit, I never thought about the fact that it is also not included in the 100% of compensation limit.

[Mike Preston]

Bingo!

[ubermax]

Another approach would be to start with basic principles which Mike outlined above instead of the worksheet in Pub 560 .

Let D=deferrals , EI = Earned Income , and N = Net Earnings From Self-Employment -

then we want D+(.25)EI <= EI or D<= (.75)EI ; now we also know that EI= (.80) N and so D <= (.75)(.80) N or (.60) N ; now if we set D=18,000 we get N = 30,000 & Profit Sharing contribution = (.20) N or 6,000 - in summary D=18000 , PS = 6,000 & Catch-up = 6,000 since we know as Mike pointed out that the Catch-up doesn't fall under the 415 limitation .

Mike , please double check what I've laid out above & thanks again for your time and insights . 

[Mike Preston]

Sorry, but I don't have time to do a thorough review of your rule set, but it appears right at first blush.