How to Calculate Solo 401k Contribution Limits

How To Calculate Solo 401k Contribution Limits

Whatever you want to call it: solo 401k, solo-k, uni-k, or one-participant-k,  the retirement plan is one of my very favorite for small business owners.  Solo 401k plans are easy to set up, low cost, and easy to maintain.  But despite the benefits, solo 401k contribution limits and the plan’s other intricacies can be murky.

 

When Can You Contribute To A Solo-401(k)?

 

The solo 401(k) is just what the name implies – a 401(k) plan for business owners without employees.

While most often utilized by sole proprietors and single member LLCs, solo 401(k)s can also be used in partnerships, multi member LLCs, S-corporations, and C-corporations as long as there are no qualifying employees.

Basically, you can make contributions in any year that you report income from self-employment on your tax return.  This can come in several forms:

  • Schedule C income from a sole proprietorship or single member LLC
  • W-2 compensation from an S-Corp or C-Corp
  • K-1 income attributable to self employment earnings, from a partnership or multi member LLC

 

Solo = No Eligible Employees

 

Not only must you have self employment income, but you can’t have any eligible employees.  This is where many business owners get tripped up, because the definition of an eligible employee can seem a bit murky.

Basically, the solo 401(k) is not much different than the traditional 401(k).  Solo 401(k) plans must have a plan document that describes how the plan is to be operated, just like traditional 401(k) plans.  Additionally, all 401(k) plans must be fair & equitable to all participants, and not discriminate in favor of highly compensated employees (or against non-highly compensated employees).

Solo 401(k) plans are no different.  They all have plan documents that must be followed, but since there are no other participants in a solo 401(k), there is no one to discriminate against.

From an administration standpoint this is great for business owners. Making sure that a traditional 401(k) is compliant requires non-discrimination testing each and every year, which can be onerous and expensive.  No employees = no testing required.

Employee Eligibility

 

Each 401(k) plan document will specify exactly what constitutes an eligible employee, and again, solo 401(k)s are not much different from traditional plans.  And while you have some discretion over your plan document, there are minimum standards for what constitutes an eligible employee.

Employees must become eligible if they work 1,000 or more hours per year, are at least 21 years old, and have at least one year of service.  Plan documents may also exclude certain union employees and nonresident aliens.  Fail any of these three, and a plan document may exclude them from eligibility if you choose.

Whatever the arrangement, remember that the plan document governs all, and that they can be more accommodating than the minimum requirements.  Your part time employees could become eligible for your plan at age 18 after working 200 hours per year, if that’s what you want.

 

No W-2 Income?  No Problem!

 

One way to get around hiring eligible employees is to hire contractors in a 1099 capacity, as opposed to full on W-2 employees.  This might be a good alternative, but keep in mind that the IRS has strict definitions of who should be considered a W-2 employee and who should be considered a contractor.

Before circumventing W-2 employees, make sure you’re not bending the IRS interpretation.

 

What If I Have a Solo 401(k) But Want To Hire Employees?

 

If you think you might want to hire employees in the next year or two, the solo 401(k) might not be for you.  As soon as you have employees who meet the eligibility requirements in your plan document, you must include them in the plan (or risk facing the wrath of the department of labor and/or the IRS).

Now, this doesn’t mean that your solo 401(k) evaporates or turns into a pumpkin if you hire someone.  It only means that you’ll have to perform the annual non-discrimination testing and jump through other hoops once you have eligible employees in the plan.

One of the solo 401(k)’s main benefits is it’s simplicity and low administration costs.  Add the wrinkle of compliance testing and all of a sudden, administration isn’t so simple.  When this happens other small business retirement plans (think SEP-IRA or SIMPLE IRA) are often more appealing.  Fortunately, terminating your solo 401(k) and starting a SEP or SIMPLE is relatively easy.

 

Implementing & Maintaining A Solo 401(k) Plan

 

Implementing a solo 401(k) plan is straight forward, and most brokerage firms offer them at very low annual costs.  New plans must be implemented by December 31st of the tax year, however contributions to the plan may be made up until the tax filing deadline.  Be careful though, as your elections as a participant must be made by the end of the tax year.
Once opened, solo 401(k)s are pretty simple to maintain.  Plans with assets over $250,000 must file form 5500 SF (short form) with the department of labor.  The standard for 5500 can be cumbersome, but the short form is considerably less so.

 

How To Calculate Solo 401k Contribution Limits

 

This is where many business owners get tripped up.  When you maintain a solo 401(k), you technically wear two hats: one as an employee and one as an employer.  You can make contributions as both.

 

Employee Contributions

As an employee, you can defer up to 100% of your compensation, or “earned income” up to $18,000 to a solo 401(k) plan.  If you’re 50 or older, you can also make catch up contributions of $6,000, totaling $24,000 in elective deferrals.
Keep in mind this is for both 2015 and 2016 – the IRS tends to bump up the contribution limits every few years.

 

Employer Contributions

As an employer, you can make profit sharing contributions to your plan.  Profit sharing contributions are limited to 25% of your compensation from an S-corp, C-corp, partnership, or multi member LLC.

Profit sharing contributions for sole proprietorships and single member LLCs are slightly more complex.  The IRS says in code 401(a)(3) that employer contributions are limited to to 25% of the business owner’s income that’s subject to self-employment tax.  And remember – because of certain deductions, not all self-employment income will be subject to self-employment tax.  Specifically, the IRS definition incorporates the deductions for half your self employment tax and contributions on your behalf to your plan.

To sort all this out, sole proprietors and single member LLC owners are required to perform an additional calculation.  The IRS has a step-by-step worksheet for this calculation in publication 560, found here, but effectively the math works out to about 20% of earned income instead of 25%.  Bankrate.com has a decent calculator.

Total contributions to the plan cannot exceed $53,000 ($59,000 for anyone age 50 or older) in 2015 and 2016.  Keep in mind that this total is for all plans per year, not just each plan per year.  If you have several businesses and set up a solo 401(k) plan for each, your contributions to the plans in total cannot surpass IRS limits.

 

Spouses

Spouses earn an exception in the eyes of the DOL.  If a business owner’s spouse earns income from the business and becomes eligible to participate in the plan, they may also contribute up to the annual limit.  This would increase the couple’s annual contribution limit to $106,000 (or $118,000) without requiring any compliance testing.

 


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Examples:

 

Sole Proprietorship or Single Member LLC

Imagine that Stephanie, 35 years old, is a sole proprietor and has $125,000 in self employment income on Schedule C of her tax return.

Stephanie may make $18,000 in employee deferrals and $25,000 ($125,000 * 20%) in profit sharing contributions, for a total of $43,000.

 

S-Corp or C-Corp

Let’s say Kyle, who is 58 years old, earned $75,000 in W-2 wages from his S-corp.  He deferred $18,000 in regular deferrals and $6,000 in catch up contributions.

His business could contribute up to $18,750 in profit sharing contributions ($75,000 * 25%), totaling $42,750 in annual contributions.  Note that Kyle’s profit sharing limit is based on $75,000 in W-2 compensation.

If Kyle’s W-2 income were $275,000, he could still make the $18,000 employee deferral and $6,000 catch up contribution, but his profit sharing contribution would be limited to $35,000 based on the aggregate limit.  This total contribution would be $18,000 + $6,000 + $35,000 = $59,000.

 

Partnership or Multi Member LLC

Now let’s say that Kyle converts his business from an S-corp to a multi member LLC, and earns $65,000.  He has several business partners but no employees.

He may still defer $18,000 as an employee and $6,000 as a catch up contribution.  But since he no longer has W-2 wages, he bases his profit sharing contribution on the K-1 income attributable to self-employment earnings.  His total contribution limit would be $18,000 + $6,000 + $16,250 ($65,000 * 25%) = $40,250.

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15 Comments

  1. In your SCorp example above, when you write, “Note that Kyle’s profit sharing limit is based on $75,000 in W-2 compensation” are you referring to the dollar figure that shows up in Box1 (Wages) or Box3 (Social security wages) or Box5 (Medicare wages and tips) of Form W-2? In other words, if say the SCorp is reimbursing Kyle $500/mo for health insurance premiums he paid out of pocket (the IRS allows, “premiums paid on behalf of a greater than 2% SCorp shareholder-employee are deductible by the SCorp and reportable as wages on the shareholder-employee’s Form W-2, subject to income tax withholding.”) then his W-2 Box1 = $75k but his Box3 and Box5 = $69k. In this situation, is your statement that, “His business could contribute up to $18,750 in profit sharing contributions ($75,000 * 25%)” still correct or is the calculation now $17,250 in profit sharing contributions ($69,000 * 25%)?

    • Hi Daniel – thanks for the question.

      My understanding is that the limit is 25% of compensation that’s subject to self-employment tax. This is the amount from which the social security tax of 12.4% is calculated (and the amount in Box 3 of a W-2).

      In your example I believe the correct calculation would then be $69,000 * 25% = $17,250. This assumes that the $500/mo reimbursement is not subject to social security wages though, which is something you might want to check with a CPA.

  2. Kyle can contribute the $18K, plus $6K catch-up amount regardless to what the other partners choose to do(?), but is his ability to increase his contribution for the profit sharing portion subject to restriction based on the other partners’ participation in that regard?
    John

    • Hi John,

      Thanks for the question. If I’m understanding you correctly, I don’t believe the actions of other partners will affect Kyle’s maximum contribution. His contribution would be based on his net earned income, from schedule K-1. At least that’s my understanding – I’m not a CPA though.

  3. Pingback: The Defined Benefits Pension Plan: Helping Business Owners Shelter Thousands from Income Tax - Above the Canopy

  4. I understand that the individual contributions to a Solo 401k must be made by Dec 31, but can the additional profit sharing contribution be made after Dec 31?

  5. “Employer Contributions
    As an employer, you can make profit sharing contributions to your plan. Profit sharing contributions are limited to 25% of your compensation from an S-corp, C-corp, partnership, or multi member LLC.”

    Can you tell me where the IRS says that a multi-member LLC contributions are 25%? Since each member of the multi-member LLC is essentially the same (tax-wise) as a single member LLC, I don’t understand why the multi-member LLC folks are allowed to contribute more (25% vs an effective 20%). It doesn’t make sense and I can’t find the IRS rule that states this.

    If this is true where does the Members Self Employed deduction accounted for and why doesn’t the multi-member end up over contributing.

    Thanks

  6. correction of the previous comment….
    What I meant to say is
    If this is true where does the multi-members Self Employed tax deduction get accounted for and why doesn’t the multi-member end up over contributing?

    It seems like the 1040 adjustments for self-employment tax would end up with a different amount for 401k “employer” portion of the deductions.

    If what you say in your blog entry is true then a multi-member LLC member is allowed to contribute/deduct more than a single member LLC member would, given an equal net income.

    From examples above….
    Single member Stephanie makes $125,000 and her employer contribution is $25,000 .
    If multi-member Kyle makes $125,000 he would have an employer contribution of $31,250

    Is that correct?

    Thanks

  7. One last entry from the IRS website that would seem to make my point, The first sentence being the most inmportant…

    “Topic Number 554 – Self-Employment Tax
    You’re self-employed for this purpose if you’re a sole proprietor (including an independent contractor), a partner in a partnership (including a member of a multi-member limited liability company (LLC) that has elected to be treated as a partnership for federal tax purposes), or are otherwise in business for yourself. The term sole proprietor also includes the member of a single member LLC that’s disregarded for federal income tax purposes and a member of a qualified joint venture. You usually must pay self-employment tax if you had net earnings from self-employment of $400 or more. Generally, the amount subject to self-employment tax is 92.35% of your net earnings from self-employment. You calculate net earnings by subtracting ordinary and necessary trade or business expenses from the gross income you derived from your trade or business. You can be liable for paying self-employment tax even if you currently receive social security benefits. The law sets a maximum amount of net earnings subject to the social security tax. This amount changes annually. All of your net earnings are subject to the Medicare tax.”

    • Hi Brian,

      I think you’re right on the money here – there’s no difference between member of a multi-member LLC and a single member LLC. I’ll make the appropriate changes to the post.
      Thanks for bringing this to my attention!

  8. I have a single member s-corp & contribute annually to a solo 401(k) each year. Unlike previous years, my W2 wages in the s-corp for 2017 is only $20,000. I am 58 year old. How much in employer contributions is allowed and how much in employee contributions is allowed? Thanks!

    • Hi Megan,

      Hypothetically, you could defer all $20,000 as an employee deferral ($18,000 + $2,000 in catch up contributions). You could also make profit sharing contributions of 25% of your W-2 wages: $20,000 * 25% = $5,000. Make sure you consider my disclaimer though, that this is not intended to be personalized advice, and I am not an accountant or an attorney.

  9. “S-Corp or C-Corp
    Let’s say Kyle, who is 58 years old, earned $75,000 in W-2 wages from his S-corp. He deferred $18,000 in regular deferrals and $6,000 in catch up contributions.

    His business could contribute up to $18,750 in profit sharing contributions ($75,000 * 25%), totaling $42,750 in annual contributions. Note that Kyle’s profit sharing limit is based on $75,000 in W-2 compensation.

    If Kyle’s W-2 income were $275,000, he could still make the $18,000 employee deferral and $6,000 catch up contribution, but his profit sharing contribution would be limited to $35,000 based on the aggregate limit. This total contribution would be $18,000 + $6,000 + $35,000 = $59,000.”

    Question: Let’s say Kyle has a WIFE that works for/earns income from the same small business, but is not the owner, but qualifies to contribute to the solo 401k… does she have to earn a certain amount to max her contribution or does she get to max it out simply because Kyle was eligible to as the company made a certain amount?

    Could you give me the same example, as illustrated above, to demonstrate how Kyle’s wife could max her contribution to the limit? From my understanding, the couple can contribute up to $118,000. Just having a hard time finding out how much the spouse has to earn for the couple to reach the $118,000 (or $106,000 if under 50).

    Thanks a million in advance!

    • Thanks for the question Blake. First off, I like the idea of adding your spouse to the company in order to make 401(k) contributions on her behalf. Be careful though. By adding her as a participant to your plan, the 401(k) is no longer “solo”. You’ll have to either perform some compliance testing each year (to ensure the plan doesn’t discriminate against certain classes of employees) or comply by the safe harbor provisions. Here’s the IRS page that describes the safe harbor plans: https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview.

      So let’s assume you amend your plan to add your spouse as a participant. They can put in $18,500 (as of 2018) as an employee. You can then add profit sharing contributions if you with. The maximum amount you can contribute will typically be 25% of her annual comp, but also depends on how the plan is set up.

      Multi participant 401(k) plans are very different than solo-k’s. They’re a great opportunity to put away more tax deferred cash as a household, but you’d probably want some help from a service provider to ensure it’s set up correctly. Also, make sure your spouse is doing bona fide work in the business & earning their comp. This is an area the IRS scrutinizes. Give me a call if you’d like to discuss further.

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