new start up solo plan that was a mistake

At least the problem was discovered very early on.......

This is a new start up solo 401k plan eff 1/1/23, only 2 months ago.  The owner is a sole prop.  While his compensation to be used for the plan was supposed to come from his sole prop business, a miscommunication somewhere resulted in him believing he could use income from other sources that would not be eligible for use in the plan.

He already made a few deposits in 2023 (not sure whether they were to be 401k, roth or after-tax).  But at this point, all parties involved just want to "walk away from the plan".  IE, take the money back out of the plan account and pretend it never happened.  Given that he is the only participant and there have been no government filings, is this acceptable or is there a better way to handle this?  What about earnings in the account?  If there is no tax deduction being used for any of the deposits, I would assume any earnings that were associated with the deposits would just be non-retirement earnings, just like it came from savings account or something similar.

Any comments are appreciated.

Don't make his problem your problem.

He has a 401(k) plan that seems to have been validly executed, a trust established, and deposits have even been made.

It sounds like he has a 401(k) Plan. If he wants to terminate it sure, you can help him with that along with the distribution, 1099-R and final Form 5500-EZ filing.

If a contribution was not labeled as an elective deferral (whether Roth or non-Roth) or as an employee contribution (if the plan’s governing documents permit such a contribution), consider whether the contribution might have been a nonelective contribution.

Unless the proprietor is confident he will have compensation (rather than a loss) for 2023, consider whether the contribution could exceed the § 415(c) annual-additions limit, a § 404 deduction limit, or some other relevant limit.

dittoing Lou - there is a 401(k) plan.  Solo or not - it does not matter, the plan is the plan.  It exists, so it has to be dealt with accordingly.  If I can only have $1 for each occurrence of "Don't make his problem your problem"......

The plan just started 1/23.  There is a lot of time to address the situation particularly since his net earnings from self-employment will not be determined until the end of the year.

The contributions so far should not be treated as elective deferrals.  I agree with Peter's observation to consider the contributions already made as non-elective employer contributions.   Then the goal for the owner is to have sufficient net earnings at plan year end (after accounting for the reductions due to the already contributed NEC and related employer-paid payroll taxes) to be able to deduct the contribution and not violate plan limits.

If his net earnings from self-employment are going to be substantially more, he then can consider making deferrals from future draw payments against self-employment compensation. 

It likely will take less time to do the math on this than it will to go through the gyrations of terminating a plan that not only has a fully executed document but also has trust assets.  There is no "never mind" solution to forget the plan did not exist.

Not a 401k expert but, why not consider the contribution as 401k deferral (assuming that the deposit amount is within 402g limits and there is a proper deferral election form)?

This way, if the income is low for 2023, one does not have to worry about deduction limit, just the 402g/415(c) limit (no 25% deduction issue for deferrals only). If the income is going to be sufficiently high for the year, then factor in additional profit-sharing allocation.

I agree with everyone that the plan exists, no question on that. If there is no income for the year, can you treat the deposit as "mistake of fact" and/or not penalized for the deposit as it would be a non-deductible amount? Of course, violation of 415(c) is another issue.

Just thinking out loud and hope did not misunderstand this discussion.

Thanks

jakyasar, you're on the right line. Just that the client should also have executed a deferral election prior to the deposits if he really wants to dot the Is and cross the Ts on doing it right.