Discussion:Self Employed 401K contributions

My client started a self employed 401K plan for his business.

He is self employed, not incorporated. He is the only person in the business. No employees.

It appears that self employed 401K plan has TWO components as far as the retirement contributions or deferrals are concerned. 1) the employee's contribution. 2) the employer's contribution.

Just want to be clear that I enter the deductions correctly on his tax return. Can someone please confirm if the following is correct?

The EMPLOYEE's deferral or contribution will be deducted on 1040 Adjusted Gross Income section under "self employed SEP, SIMPLE and QUALIFIED PLANS".

The EMPLOYER's deferral or contribution, since my client is self employed filing a Schedule C, the employer's deferral or contribution will be deducted on Schedule C in the EXPENSE section under "Pension and Profit Sharing Plans".

Is the above treatment correct?

Last but not least, are there any differences in terms of tax treatment for the EMPLOYEE'S deferral and the EMPLOYER'S deferrals when my client eventually reaches retirement age and has to withdraw the money?

I know the annual contribution limits are different for the EMPLOYEE's portion and the EMPLOYER's portion. But just curious about the tax implications when my client retires and need to take the money out, would the EMPLOYEE portion and EMPLOYER portion be subject to different tax treatment upon withdrawal?

Again, he is self employed with no employees, unincorporated.

Thanks in advance.

Your client has what is known as a solo or individual 401(k). He may deduct up to $15,500 of 401(k) contributions and $5,000 of catch up contributions (if over age 50) provided he has that much net income. You have the right line of Form 1040.

Since he is self-employed, he is not an employee, nor is he an employer. The rules regarding employer contributions/employee deferral only apply in an environment where you have employees.

There is no deduction on Schedule C for his 401(k) deduction.

As Beach states, while no deduction is taken on Schedule C, his deductible contribution is limited to the lower of Schedule C net income or $15,500 ($20,500 if over 50). Since it's above the line, it's as good as taking it on Schedule C anyway.

I guess I got confused with the example given on Fidelity's website. (that's where my client has his solo 401K btw).

In the example titled "How a Self-Employed 401(k) contribution can add up", they seem to suggest that the taxpayer can double dip and have TWO separate & different contributions/deductions, one on his schedule C and the other on 1040. http://personal.fidelity.com/products/retirement/getstart/newacc/keogh.shtml.cvsr

Note that Fidelity may refuse to take the 2008 elective deferral contribution after 12/31/2008. I think they're wrong, but that's their practice. I only happen to know this stuff because I have a SE 401K plan at Pioneer and my wife has one at Fidelity and their rules differ.

DavidH

Yeah, it does sound too good to be true, the taxpayer can defer up to the cap of $46K (employee and employer combined) per year with this plan. That's huge for a single person owner run business.

Do you know the tax treatment when the owner retires one day and wants to withdrawl the funds? Since there are two seperate pools of contributions/deferrals, I wonder if there are different tax treatments for each when the owner retires one day. The plan sounds way too generous in my opinion. I am trying to anticipate any surprises that may come when my client retires one day.

As for employee's salary deferral, I spoke to a Fidelity rep about that a while back and he said it would be ok to contribute before the tax filing deadline as long as the plan is set up by Dec 31 of the tax return year. I will double check with them again.

Thanks again.

Want to know another too good to be true? Some plans (NOT Fidelity) allow loans from the 401K. I just borrowed $50K (the max) from my Pioneer solo plan. I need to pay in back in five years, but the kicker is that I'm paying interest to myself (and probably getting a better return on my money than if I had it in stocks these days).

David H

For purposes of WHEN a distribution is allowed, there'a difference. The employee's own deferrals can be distributed only upon the limited occasions mentioned under IRC 401(k)(2)-----attainment of age 59 1/2, hardship, severance from employment, et al. So most people will have to leave the employer to be eligible to get their benefit. Most plans do not allow inservice distributions at age 59 1/2, even though the law allows it. A few strict ones don't even distribute to a separated employee, unless the employee has met the plan's stated retirement age or perhaps age 59 1/2.

On the other hand, a plan could allow for employer profit sharing contributions to be distributed upon the occurrence of any of a multitude of stated events. Most plans don't allow for this but those that do usually state the events to be when a person has been a plan participant for 5 years or when a given dollar has been in the plan for 2 years.

With a defined benefit plan, you might say the sky's the limit on deducting. But a whole lot more overhead accompanies a DB plan, not the least of which is required minimum funding.

It seems to me a Schedule C deduction is better than one on line 28 of Form 1040. A Schedule C deduction reduces self employment tax. For the W-2 employees of a sole proprietor, their elective deferrals are included in their salary on Schedule C. The profit sharing contribution on their behalf is also a Schedule C deduction.

Salary deferral elections need to be made before the compensation becomes 'currently available.' This term is looser than constructive receipt. So I guess that's where the sole proprietor is able to take up until the extended due date to put the deferral money into the trust. But a sole proprietor with employees would be required to conbtribute everybody's deferrals by the Department of Labor's deadline, "as soon as administratively feasible (which they emphasize), but in no event later than the 15th business day of the month following the month deferred."

W-2 employees can defer regarding paydays through December 31.  So if your W-2 employee makes the employee deferral election on December 1 but wants to defer $15,500, she must get a pretty large paycheck or two in December.  Partners must defer by December 31.  Maybe that's involved in the confusion over deadline dates mentioned a few posts above.     

Some versions of the plan now contain the Roth 401(k) feature. The employee can split up the $15,500 of deferrals between pretax and Roth. The Roth part must be separately accounted for. It's subject to the RMD rules, unlike a Roth Ira. But a Roth 401(k) can be rolled to a Roth Ira.

David H

Sorry about the confusion on the elective deferral contribution deadline for self employeds. I was looking at I.R. reg 1.401(k)-1(a)(6)(iii), as commented on in a BNA portfolio, while trying to find some reason one of the brokers above would not accept post 12/31 contributions. It's the written ELECTION to defer which must be done before the funds become currently available. The 'currently available' concept is relevant; the reg. says a partner's earnings are currently available on the last day of the partnership year. A sole proprietor's compensation is currently available when the tax return is due. BNA comments that 'presumably the partnership rule regards only earnings actually received by the partner as of the last day of the partnership year'.