Q: I have a self-employed 401(k) plan. How do I calculate my contribution limit? Is it pre-income and pre-self employment tax? How do I report it on the 1040?
Bryan, Somewhere USA
A: The self-employed 401(k) is one of the most powerful tax-reduction tools available to the independent entrepreneur. As both the "employer" and the "employee," you can make a boatload of retirement plan contributions. There are some special rules you need to observe, though...
First, some background. There are two families of tax-advantaged savings vehicles: IRAs, and workplace retirement plans. The former are available to anyone with eligible compensation (usually wages and self-employment earnings). The latter (401k plans being the most prevalent) are only available by the good graces of your boss.
What if you are your own boss? If you are an unincorporated small business, you have several options available to you:
- A defined-benefit pension. These are usually most-advantageous to older sole proprietors;
- SEP-IRA plans, where you can contribute up to 20% of net income from self-employment;
- Self-Employed 401(k) plans, which we are discussing here
With limited exceptions, these choices are mutually-exclusive (with some limited double-dipping between DB plans and the other two). For younger self-employed persons looking to sock away money for retirement, the self-employed 401(k) plan is the way to go.
A self-employed 401(k) plan does not have the same non-discrimination rules as regular 401(k) plans do. As such, they can only cover the business owner and his spouse. If you have other employees, you probably need to get a regular 401(k) plan.
Here's how it works. There are two contributions to this 401(k) plan, just like any other. The employee's elective deferral is up to $15,500 for 2008 ($20,500 if over age 50). This can either be done pre-tax, or as an after-tax "Roth deferral" contribution.
The other part of the contribution is on the employer side. This contribution is limited to 20% of net income from self-employment. "Net income from self-employment" is defined as Business Income (from line 12 of the 1040) reduced by that business' share of the adjustment for one-half of self-employment tax paid (from line 27 of the 1040).
Combined, these two numbers (along with any other workplace plan participation and contributions) cannot exceed the aggregate annual limit on defined contribution retirement plan payments for any individual ($46,000 in 2008).
Let's take someone with $100,000 in Box-12 self-employment income. How much can he put in?
20% of ($100,000 minus $7065), or $18,587
That's quite a wallop. In one fell swoop, this entrepreneur can put away more than third of his profits toward retirement.
It's not all roses, though. For one thing, the self-employed 401(k) deduction is not pre-SECA--it's only pre-income tax. It's taken as an adjustment on line 28 of the 1040. In an incorporated business' 401(k) plan, the employer contribution would be pre-FICA.
Another limit is the "20% of net" rule. In an incorporated business, the limit is 25% of compensation (usually gross wages). Not only is this a bigger amount, it isn't reduced by any payroll tax deductions.
Still, this is a powerful tool for the self-employed. One advantage these plans have over incorporated business' 401(k) plans is that the contribution deadline is not December 31st, but the tax-filing deadline (plus extensions).