Self-Employed 401(k):What Is It, How Does It Work?

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:

1. A defined-benefit pension.  These are usually most-advantageous to older sole proprietors;
2. SEP-IRA plans, where you can contribute up to 20% of net income from self-employment;
3. 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?

$15,500 plus
20% of ($100,000 minus $7065), or $18,587
========================================
TOTAL: $34,087

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).

Comments

[Bryan J Cavill]

very helpful....just on question...if I am unincorporated does the calculation or the tax position change?

At least I am old...well 62 so I get the catch up.

[Ryan Ellis]

Just updated the post. For Bryan, the maximum "elective deferral" is $20,000 for 2006, and $20,500 for 2007.

Not sure I understand the question about being unincorporated. The limits and opportunities are described in the post.

[Baby Boomer Jerr]

I have not really looked into this avenue. I currently contribute to an SEP IRA and get some nice tax benefit from that. Thanks for the info.

Jerr

[Cal]

What initial filing and registration requirements are required to form the self-employed 401(k)?

[Eric]

I would like to transfer existing corporate 401(k) funds into a self-directed plan. Is this permissible? Would I need an IRS determination letter to validate my self-directed plan?

[BRIAN]

Hi,
I'm a 40 yr old dentist and i am about to implement some sort of retirement plan for myself and my employees. i was told it's too late to institute a 401k plan for 07 but not too late to have the profit sharing plan for the office and then early next year convert it over to a 401k plan. my salary is above the 225k maximun limit. For me to take advantage of the max of 45k for me, i then have to contribute 20% of all employees eligible.
is that correct?
thanks.

[Ripper]

I have a SEP IRA. One of the things I like about is the flexibiity of contribution, some years I can make the maximum contribution, some years I am not able to make any contribution.
Is the self employed 401 K similarly flexible, would I be able to make the maximum contribution during one year and not be obligated to make any contribution the next year?

[Sam]

I have a 401K with my previous employer. Currently I do trading (stock), my gross earning would be close to 125K. My wife is employed and she has her own 401k with her employer. Can I open another 401K and upto how much I can contribute (if my net incom online 12 would be $100k)?

[Dr Thompson]

Thank you for your very well written article about self employed retirement plans. This is the first time that I have seen a tax professional reference where to take the various deductions (i.e. line 14 of the 1040 etc) and it was very helpful.

After reading your information I did some additional research and found a website that provides detailed information about the Individual 401k, Defined Benefit Plan and SEP IRA. This was a particularly informative website and wanted to pass it along to other self employed people http://www.individual401k.com.

Thanks again for helping me better understand my self employed retirement plan options.

[Susan]

There is however a different calculation needed if you are in the lower self employment income realm... I just ran my solo 401k numbers on the TurboTax/IRS Keogh, SEP and SIMPLE contribution worksheet, and it lowered the employer amount I could contribute to almost 10%. It calculated the difference between my full personal contribution $15,500 and my adjusted self employment income (net less 1/2 SE Tax), and then halved that? and that (reduced employer amount plus max $15,500) was the max deductible I says I can claim... IRS quoted publication 560/page 14 to me.

[George]

This is a excellent site, provide a lof info.

Can a self employed contribute full elective deferral (15500) to individul 401k if that's more than the net profit? Here is the numbers:
Gross incoem 25000
expenses 12000
net profit 13000 ( less than elective deferral 15500)
Can I also do the 20% net profit (for employer) contribution?

Thanks in advance.

George

[joe blough]

Max elective deferral is lesser of 15, 500 for 08' or net profit. U may not contribute more than the 13,000 in this case.

[don]

My SE income is well above the amount that would yeild the full 50,000 deduction (I am over 50). How do I determine the right (or best) way to split the deduction between the business contribution and the individual contribution?

[charlie]

I have a Simple-IRA at work and have a salary deferral of $13,000 (I am over 50). I also have self-employment income from a side consulting business. It seems to me that I could do an Solo 401k elective salary deferral of $15,500 - $13,000 + $5000 catchup and add to that 25% of my business profits. Does this seem right?

[Skrabichewski]

Fidelity has a great self-401k calculation worksheet PDF form available on their site (somewhere in "retirement"->"self-employed" ->self-401k section). You don't need to be Fidelity customer to download it -- give it to your accountant and ask him/her to follow it (it is really self-explanatory step by step calculations). It might be too late for some, but this form was MEGA useful for me. And don't forget -- the funds have to be deposited to your 401k account by April 15 not just postmarked.