53k in 401k as a biz owner?

[wearfannypacks]

How can I make use of a 401k as a business owner?

I currently use a SEP IRA, I only qualified to contribute 11k in 2016. SEP you can only contribute 25% of your income. After calculations it end up being about 20%. I made about 62 K last year. I'd love for most of that to go to tax deferred retirement account. My DH and I are in a really high tax bracket and I want to reduce it as much as possible.

I want to contribute THE MAX to tax deferred accounts. I have 2 employees, so technically I could create at 401k. Since I'm calling the shots as an individual and a practice owner, I could max it out. I don't know how to go about doing that. I'll need to optimize fees and tax savings.

Any good resources? Plan administrators? Mustachian methods of doing a 401k?

[khizr]

There are a lot of rules on 401ks if you are the owner of the business, and more than likely if your other two employees don't contribute much you won't be allowed to either. For example, let's say that you contribute the max of $18k, on a salary of $60k. The IRS rules say that since you are giving around 30%, if the other employees arn't you have to give it back and use their average since you own more than 5% of the business.

(disclaimer, I am not a lawyer but have had this happen to me a few times)

Link -> http://blog.employeefiduciary.com/blog/is-your-company-part-of-a-controlled-group-you-need-to-know-or-risk-401k-plan-disqualification

So if you do an 401k, you can probably put in about 7% a year of your salary without raising flags, but you need to talk to a specialist / lawyer to help on that. It depends on what your two employees do.

[maizefolk]

This is where "safe harbor" rules are quite helpful. You just have to have your business contribute 3% of each employee's salary to their own 401k accounts,* and it helps avoid a lot of the issues with top heavy tests and high compensated employee tests. That gets you your 18k of "employee" contributions. Getting the full $53k through is still going to require more gymnastics (since presumably you don't want to put equivalent amounts into the accounts of each of your employees), and would at a bare minimum is also going to require you to me making on the order of a quarter million dollars a year in profit.

*There are other ways of getting a safe harbor plan with matches instead of automatic contributions.

[wearfannypacks]

My employees are part-time and work less than 1000 hours a year. After much digging, it looks like I qualify for a solo 401k. hurray.

I guess I can contribute more than with a SEP. I prefer low fee index fund investing. Anyone have plan admin recs?

Edit: I currently use vangaurd admiral shares in an Total stock market index fund at 0.05% fees.  I believe I read that Fidelity's equivalent fund is at 0.035%?

[SeattleCPA]

I would caution you about a 401(k) plan if you have employees. I did see that currently neither employee qualifies... but if that changes in future, you're going to run into lots of increased costs once you upgrade your 401(k) plan to handle more than just you...

The big issue, I think, is the permanency requirement, as discussed in more detail about half way down this blog post:

http://evergreensmallbusiness.com/hidden-small-business-pension-plan-costs/

For what it's worth, I would love to personally MAX my accounts too. But because I work with employees in my CPA firm and no one else on team values the higher elective deferral limits of a 401(k) as compared to a Simple-IRA plan, we use a Simple-IRA plan.

I.e., it just doesn't pencil out to pay $2K, $3K or $4K annually to move your elective deferral from $12.5K to $18K or from $15.5K to $24K.

[Malum Prohibitum]

Well, you can't do $53k in the 401(k) on income of $62k (by the way, the limit is $54k, not 53).  You can do $18k deferral from your paycheck.  $1500 a month.  Your corporation can then match or contribute, but that corporate match is limited to 25% of your W-2 compensation. 

If you are 50 or over you are entitled to an additional 6 grand.

So your employer can contribute $36,000, but only if that is 25% of your W-2 compensation, that is, $144,000.

[SeattleCPA]

Roughly (roughly) with $62K of sole proprietorship profits, someone could do $18K plus another $12K (20% of the $62K) or $30K in total.

If this is a partnership with two partners (spouses say) they could do $18K plus $18K plus another $12K, so $48K in total.

BTW if you're an S corporation making $62K, that $62K doesn't matter. (Hopefully you're not because it wouldn't make sense in your situation probably.) But in this situation, you can do the greater of 100% of your W-2 wages plus 25% of your W-2 wages. E.g., if $20K of the $62K is wages, you can do $18K plus another $5K.

BTW, some of the employer percentages are 20% and some are 25%... but it turns out those are the same numbers. Basically. The 20% can also be described as 25% after the 25%... which is the same thing as 20%. Pretty much.

E.g. and making the math easy, if your sole proprietorship made $125K a year, you could contribute roughly 20% of $125K or $25K. But that 25K is $25% of the $125K business profit after you've subtracted the $25K match.

[maizefolk]

BTW, some of the employer percentages are 20% and some are 25%... but it turns out those are the same numbers. Basically. The 20% can also be described as 25% after the 25%... which is the same thing as 20%. Pretty much.

This used to confuse me a lot until I realized the sample point you describe above which wasn't clearly stated anywhere in the rules I was reading.

It's not a question of different business structures having better or worse treatment. It's that you can either contribute 20% of the total amount of money you made, or 25% of the money you made excluding your contributions (which would be 20% of your total money available for profit + contributions).

So it works out to the exact same sum of money either way.

[wearfannypacks]

Roughly (roughly) with $62K of sole proprietorship profits, someone could do $18K plus another $12K (20% of the $62K) or $30K in total.

If this is a partnership with two partners (spouses say) they could do $18K plus $18K plus another $12K, so $48K in total.

BTW if you're an S corporation making $62K, that $62K doesn't matter. (Hopefully you're not because it wouldn't make sense in your situation probably.) But in this situation, you can do the greater of 100% of your W-2 wages plus 25% of your W-2 wages. E.g., if $20K of the $62K is wages, you can do $18K plus another $5K.

BTW, some of the employer percentages are 20% and some are 25%... but it turns out those are the same numbers. Basically. The 20% can also be described as 25% after the 25%... which is the same thing as 20%. Pretty much.

E.g. and making the math easy, if your sole proprietorship made $125K a year, you could contribute roughly 20% of $125K or $25K. But that 25K is $25% of the $125K business profit after you've subtracted the $25K match.

Wow, such great information. Thanks for explaining the math. I appreciate all the specific details. I'm the sole shareholder in a PLLC (no s-corp election.) With my spouses income we will be in the 33% tax bracket next year. An additional 18k in contributions saves us 6k in taxes this year.

How does adding a spouse to the solo 401k work? Do they have to be a shareholder? Would I have to pay his FICA before we could contribute? I guess that might all even out because I pay FICA on it all anyway. It would just be technically split between the 2 of us. I'd love to reduce our tax burden as much as possible because we are at the peak of our taxable income in these years.

I would caution you about a 401(k) plan if you have employees. I did see that currently neither employee qualifies... but if that changes in future, you're going to run into lots of increased costs once you upgrade your 401(k) plan to handle more than just you...

The big issue, I think, is the permanency requirement, as discussed in more detail about half way down this blog post:

http://evergreensmallbusiness.com/hidden-small-business-pension-plan-costs/

For what it's worth, I would love to personally MAX my accounts too. But because I work with employees in my CPA firm and no one else on team values the higher elective deferral limits of a 401(k) as compared to a Simple-IRA plan, we use a Simple-IRA plan.

I.e., it just doesn't pencil out to pay $2K, $3K or $4K annually to move your elective deferral from $12.5K to $18K or from $15.5K to $24K.

Ya, I hear what you are saying. Those are good questions to consider. I don't believe I was to expand. I like my small-part time, leave on vacation whenever my husband has off kind of practice. I also hadn't considered the permancy clause. Lemme type out my thoughts as I review. My business is a little unusual. If I'm busy enough to need to contribute to employee 401k, I will gladly match them. They are entry level hourly rate. I imagine my salary would increase so I'd be maxing out the 401k and the 2-6k admin fees are lower than my tax benefit. My total employee hours last month were 28 hours. Last year I had 210 hours total between 3 very part-time employees who are college students I pay $10 an hour. If I was my own employee, I probably wouldn't qualify for 1000 working hours a year. I don't have a desire to expand. I'm planning on selling or passing on my practice to someone else when I'm ready to FIRE.

[Malum Prohibitum]

Roughly (roughly) with $62K of sole proprietorship profits, someone could do $18K plus another $12K (20% of the $62K) or $30K in total.

If this is a partnership with two partners (spouses say) they could do $18K plus $18K plus another $12K, so $48K in total.

BTW if you're an S corporation making $62K, that $62K doesn't matter. (Hopefully you're not because it wouldn't make sense in your situation probably.) But in this situation, you can do the greater of 100% of your W-2 wages plus 25% of your W-2 wages. E.g., if $20K of the $62K is wages, you can do $18K plus another $5K.

BTW, some of the employer percentages are 20% and some are 25%... but it turns out those are the same numbers. Basically. The 20% can also be described as 25% after the 25%... which is the same thing as 20%. Pretty much.

E.g. and making the math easy, if your sole proprietorship made $125K a year, you could contribute roughly 20% of $125K or $25K. But that 25K is $25% of the $125K business profit after you've subtracted the $25K match.

I was very confused and had to read your post three times, very slowly.  I think I get it now, and I also think that it does not contradict what I wrote in Reply #5.  Is everything in my Reply #5 accurate?  I am asking more for myself than the original poster (I do have an S corp).

[Much Fishing to Do]

Is everything in my Reply #5 accurate?  I am asking more for myself than the original poster (I do have an S corp).

I think your take is correct Malum.  I'm an S Corp with no other employees, which does keep this simple.  Before starting a business, in the same type of work, I used to make around $150k or so.  So now I just set my salary every year to whatever is 4x the max employer contribution.  This lets me always do the max, while also knowing that my salary is an appropriate one for me anyway as it should inflate normally with the index that inflates the limits.

[SeattleCPA]

Roughly (roughly) with $62K of sole proprietorship profits, someone could do $18K plus another $12K (20% of the $62K) or $30K in total.

If this is a partnership with two partners (spouses say) they could do $18K plus $18K plus another $12K, so $48K in total.

BTW if you're an S corporation making $62K, that $62K doesn't matter. (Hopefully you're not because it wouldn't make sense in your situation probably.) But in this situation, you can do the greater of 100% of your W-2 wages plus 25% of your W-2 wages. E.g., if $20K of the $62K is wages, you can do $18K plus another $5K.

BTW, some of the employer percentages are 20% and some are 25%... but it turns out those are the same numbers. Basically. The 20% can also be described as 25% after the 25%... which is the same thing as 20%. Pretty much.

E.g. and making the math easy, if your sole proprietorship made $125K a year, you could contribute roughly 20% of $125K or $25K. But that 25K is $25% of the $125K business profit after you've subtracted the $25K match.

I was very confused and had to read your post three times, very slowly.  I think I get it now, and I also think that it does not contradict what I wrote in Reply #5.  Is everything in my Reply #5 accurate?  I am asking more for myself than the original poster (I do have an S corp).

Sorry... and you're right, what you're saying and what I'm saying are the same thing. (Er, me with less clarity obviously! :-( )

[SeattleCPA]

Roughly (roughly) with $62K of sole proprietorship profits, someone could do $18K plus another $12K (20% of the $62K) or $30K in total.

If this is a partnership with two partners (spouses say) they could do $18K plus $18K plus another $12K, so $48K in total.

BTW if you're an S corporation making $62K, that $62K doesn't matter. (Hopefully you're not because it wouldn't make sense in your situation probably.) But in this situation, you can do the greater of 100% of your W-2 wages plus 25% of your W-2 wages. E.g., if $20K of the $62K is wages, you can do $18K plus another $5K.

BTW, some of the employer percentages are 20% and some are 25%... but it turns out those are the same numbers. Basically. The 20% can also be described as 25% after the 25%... which is the same thing as 20%. Pretty much.

E.g. and making the math easy, if your sole proprietorship made $125K a year, you could contribute roughly 20% of $125K or $25K. But that 25K is $25% of the $125K business profit after you've subtracted the $25K match.

Wow, such great information. Thanks for explaining the math. I appreciate all the specific details. I'm the sole shareholder in a PLLC (no s-corp election.) With my spouses income we will be in the 33% tax bracket next year. An additional 18k in contributions saves us 6k in taxes this year.

How does adding a spouse to the solo 401k work? Do they have to be a shareholder? Would I have to pay his FICA before we could contribute? I guess that might all even out because I pay FICA on it all anyway. It would just be technically split between the 2 of us. I'd love to reduce our tax burden as much as possible because we are at the peak of our taxable income in these years.

I would caution you about a 401(k) plan if you have employees. I did see that currently neither employee qualifies... but if that changes in future, you're going to run into lots of increased costs once you upgrade your 401(k) plan to handle more than just you...

The big issue, I think, is the permanency requirement, as discussed in more detail about half way down this blog post:

http://evergreensmallbusiness.com/hidden-small-business-pension-plan-costs/

For what it's worth, I would love to personally MAX my accounts too. But because I work with employees in my CPA firm and no one else on team values the higher elective deferral limits of a 401(k) as compared to a Simple-IRA plan, we use a Simple-IRA plan.

I.e., it just doesn't pencil out to pay $2K, $3K or $4K annually to move your elective deferral from $12.5K to $18K or from $15.5K to $24K.

Ya, I hear what you are saying. Those are good questions to consider. I don't believe I was to expand. I like my small-part time, leave on vacation whenever my husband has off kind of practice. I also hadn't considered the permancy clause. Lemme type out my thoughts as I review. My business is a little unusual. If I'm busy enough to need to contribute to employee 401k, I will gladly match them. They are entry level hourly rate. I imagine my salary would increase so I'd be maxing out the 401k and the 2-6k admin fees are lower than my tax benefit. My total employee hours last month were 28 hours. Last year I had 210 hours total between 3 very part-time employees who are college students I pay $10 an hour. If I was my own employee, I probably wouldn't qualify for 1000 working hours a year. I don't have a desire to expand. I'm planning on selling or passing on my practice to someone else when I'm ready to FIRE.

Just to respond to the phase I boldfaced in your message... it is very hard to justify spending admin fees on the basis of a higher tax deferral. One wants to be careful to remember the tax deferral benefit gets "reversed" later on... and those admin fees are gone forever.

[SeattleCPA]

Is everything in my Reply #5 accurate?  I am asking more for myself than the original poster (I do have an S corp).

I think your take is correct Malum.  I'm an S Corp with no other employees, which does keep this simple.  Before starting a business, in the same type of work, I used to make around $150k or so.  So now I just set my salary every year to whatever is 4x the max employer contribution.  This lets me always do the max, while also knowing that my salary is an appropriate one for me anyway as it should inflate normally with the index that inflates the limits.

Okay, so a similar issue exists with paying a higher wage so you can do a higher pension contribution... The tax deferral benefit probably isn't enough to justify those extra payroll taxes. Usually you want to get your S corp salary as low as you possibly can and ignore the pension stuff.

[Much Fishing to Do]

Is everything in my Reply #5 accurate?  I am asking more for myself than the original poster (I do have an S corp).

I think your take is correct Malum.  I'm an S Corp with no other employees, which does keep this simple.  Before starting a business, in the same type of work, I used to make around $150k or so.  So now I just set my salary every year to whatever is 4x the max employer contribution.  This lets me always do the max, while also knowing that my salary is an appropriate one for me anyway as it should inflate normally with the index that inflates the limits.

Okay, so a similar issue exists with paying a higher wage so you can do a higher pension contribution... The tax deferral benefit probably isn't enough to justify those extra payroll taxes. Usually you want to get your S corp salary as low as you possibly can and ignore the pension stuff.

I totally agree at certain levels, every thousand of salary generally would be costing me 15% of payroll (actually less as I can deduct some of this) and only providing me an 8% break ($250 additional contribution @ 33% tax break).  The thing is above the SS cap each 1k is only costing me the medicare part, lower than the break i get.  I could figure out how much below the salary cap I'd have to go where the overall payroll break would exceed the overall deduction break, but I that point I think I'm probably below my reasonable salary at the profit I'm currently making.

[SeattleCPA]

Is everything in my Reply #5 accurate?  I am asking more for myself than the original poster (I do have an S corp).

I think your take is correct Malum.  I'm an S Corp with no other employees, which does keep this simple.  Before starting a business, in the same type of work, I used to make around $150k or so.  So now I just set my salary every year to whatever is 4x the max employer contribution.  This lets me always do the max, while also knowing that my salary is an appropriate one for me anyway as it should inflate normally with the index that inflates the limits.

Okay, so a similar issue exists with paying a higher wage so you can do a higher pension contribution... The tax deferral benefit probably isn't enough to justify those extra payroll taxes. Usually you want to get your S corp salary as low as you possibly can and ignore the pension stuff.

I totally agree at certain levels, every thousand of salary generally would be costing me 15% of payroll (actually less as I can deduct some of this) and only providing me an 8% break ($250 additional contribution @ 33% tax break).  The thing is above the SS cap each 1k is only costing me the medicare part, lower than the break i get.  I could figure out how much below the salary cap I'd have to go where the overall payroll break would exceed the overall deduction break, but I that point I think I'm probably below my reasonable salary at the profit I'm currently making.

For what it's worth...

I've done the calculations hundreds of times for different client situations... and almost, almost always the numbers don't support a higher salary for higher pension fund contributions. But the math gets tedious. Some things you want to model:

1. The 2.9% or 3.8% Medicare and Obamacare tax burden (and deduction).
2. State payroll taxes... and state S corporation franchise taxes as well.
3. The true benefit of the deferral... I.e., you may get a 25% tax savings when you put money into the plan but then need to remember you may pay 15% when you take the money out.
4. The loss of the preferential tax treatment you would have received on the income if you'd invested same sum in a taxable but tax efficient container.
5. Current and future costs of the pension plan... E.g., the permanency requirement mentioned above.

One wants to be careful about applying general rules to specific situations. But I think the best general rule is set you S corp salary to the lowest reasonable level you can.

P.S. We may have different senses about what you can set your S corporation salary level too...

[Much Fishing to Do]

Is everything in my Reply #5 accurate?  I am asking more for myself than the original poster (I do have an S corp).

I think your take is correct Malum.  I'm an S Corp with no other employees, which does keep this simple.  Before starting a business, in the same type of work, I used to make around $150k or so.  So now I just set my salary every year to whatever is 4x the max employer contribution.  This lets me always do the max, while also knowing that my salary is an appropriate one for me anyway as it should inflate normally with the index that inflates the limits.

Okay, so a similar issue exists with paying a higher wage so you can do a higher pension contribution... The tax deferral benefit probably isn't enough to justify those extra payroll taxes. Usually you want to get your S corp salary as low as you possibly can and ignore the pension stuff.

I totally agree at certain levels, every thousand of salary generally would be costing me 15% of payroll (actually less as I can deduct some of this) and only providing me an 8% break ($250 additional contribution @ 33% tax break).  The thing is above the SS cap each 1k is only costing me the medicare part, lower than the break i get.  I could figure out how much below the salary cap I'd have to go where the overall payroll break would exceed the overall deduction break, but I that point I think I'm probably below my reasonable salary at the profit I'm currently making.

For what it's worth...

I've done the calculations hundreds of times for different client situations... and almost, almost always the numbers don't support a higher salary for higher pension fund contributions. But the math gets tedious. Some things you want to model:

1. The 2.9% or 3.8% Medicare and Obamacare tax burden (and deduction).
2. State payroll taxes... and state S corporation franchise taxes as well.
3. The true benefit of the deferral... I.e., you may get a 25% tax savings when you put money into the plan but then need to remember you may pay 15% when you take the money out.
4. The loss of the preferential tax treatment you would have received on the income if you'd invested same sum in a taxable but tax efficient container.
5. Current and future costs of the pension plan... E.g., the permanency requirement mentioned above.

One wants to be careful about applying general rules to specific situations. But I think the best general rule is set you S corp salary to the lowest reasonable level you can.

P.S. We may have different senses about what you can set your S corporation salary level too...

Thanks! Those are some really good points.  It doesn't really effect my state, but #3&4 I do see i have not factored in and could be significant.

And yes, I guess if I set my salary at $25k then I would save money, but given some years I net $400-$500k, and I used to make around $150k as an employee doing this type of work, that seems like it would have to come back and bite me at some point, though maybe that's being naive on my part, its still soooo bizaar to me how much one can just pick numbers that actually affect the bottom line

[tralfamadorian]

I went through the same process when I opened a solo 401k for my small business where I employ seasonal part-time employees.  Even though the hours were nowhere close to the limits, the average employment time frame was less than six months and I usually employ college students, plan providers avoided me like the plague.

The only plan provider that would work with me was Fidelity.  FYI.

[SeattleCPA]

I guess if I set my salary at $25k then I would save money, but given some years I net $400-$500k, and I used to make around $150k as an employee doing this type of work, that seems like it would have to come back and bite me at some point, though maybe that's being naive on my part, its still soooo bizaar to me how much one can just pick numbers that actually affect the bottom line

I think you might have more flexibility that people usually think, though you need to set your salary carefully. The rule is, it's got to be reasonable...

But then I'll also note that Warren Buffet earns $100K a year so, if that's what he's worth...

[GetSmart]

So now you have me wondering if I'm doing this right. Are we required to draw a salary from a side business in order to use a 401k?  I assumed since it is pass-thru income that it was possible to put all the profits into a 401k (so far always less than 30k/yr-and 50/50 partnership- no employees).  Or is this the same as saying my salary was 15k and I deferred the entirety to my 401k?

[tralfamadorian]

So now you have me wondering if I'm doing this right. Are we required to draw a salary from a side business in order to use a 401k?  I assumed since it is pass-thru income that it was possible to put all the profits into a 401k (so far always less than 30k/yr-and 50/50 partnership- no employees).  Or is this the same as saying my salary was 15k and I deferred the entirety to my 401k?

Presuming 30k business profits:

If you elect to be taxed as a LLC (schedule C), then you can contribute 18k plus 20% of the total profit. (24k in total)

If you elect to be taxed as a S Corp (K-1), then you can contribute 18K -or the total of your W2 salary if <18K- plus 25% of that salary. (18.75k in total if you drew a 15k salary)

[Malum Prohibitum]

So now you have me wondering if I'm doing this right. Are we required to draw a salary from a side business in order to use a 401k?  I assumed since it is pass-thru income that it was possible to put all the profits into a 401k (so far always less than 30k/yr-and 50/50 partnership- no employees).  Or is this the same as saying my salary was 15k and I deferred the entirety to my 401k?

Presuming 30k business profits:

If you elect to be taxed as a LLC (schedule C), then you can contribute 18k plus 20% of the total profit. (24k in total)

If you elect to be taxed as a S Corp (K-1), then you can contribute 18K -or the total of your W2 salary if <18K- plus 25% of that salary. (18.75k in total if you drew a 15k salary)

But the LLC person who works for the LLC has to pay self employment tax on the entire amount, correct? 

[Malum Prohibitum]

For what it's worth...

I've done the calculations hundreds of times for different client situations... and almost, almost always the numbers don't support a higher salary for higher pension fund contributions. But the math gets tedious. Some things you want to model:

1. The 2.9% or 3.8% Medicare and Obamacare tax burden (and deduction).
2. State payroll taxes... and state S corporation franchise taxes as well.
3. The true benefit of the deferral... I.e., you may get a 25% tax savings when you put money into the plan but then need to remember you may pay 15% when you take the money out.
4. The loss of the preferential tax treatment you would have received on the income if you'd invested same sum in a taxable but tax efficient container.
5. Current and future costs of the pension plan... E.g., the permanency requirement mentioned above.

One wants to be careful about applying general rules to specific situations. But I think the best general rule is set you S corp salary to the lowest reasonable level you can.

P.S. We may have different senses about what you can set your S corporation salary level too...

Every time you post you upset my assumptions!

So, assume $200K in business income after expenses for S Corp.  Pay self $50k in wages.  Of that $50k, you put $24k in salary deferral into 401(k) (because 50 years old or over).   That leaves $26k.  You can also match another $12,500, so $36,500 into the 401(k).

Self employment taxes on the $50k.

Income tax only on the $150k and the $26k wages left over after the salary deferral to the 401(k).

Plus $12,000 or so health insurance premiums deductible as a business expense but gets added to your W-2 (is that taxed?)

Am I thinking clearly on this?

[Malum Prohibitum]

So now you have me wondering if I'm doing this right. Are we required to draw a salary from a side business in order to use a 401k?  I assumed since it is pass-thru income that it was possible to put all the profits into a 401k (so far always less than 30k/yr-and 50/50 partnership- no employees).  Or is this the same as saying my salary was 15k and I deferred the entirety to my 401k?

Only w-2 income may be put into the 401(k), and the match maximum is calculated as a percentage of your W-2 compensation.

[tralfamadorian]

But the LLC person who works for the LLC has to pay self employment tax on the entire amount, correct?

Exactly.  Which is why there is a break even point where the additional tax costs of the S corp and payroll are outweighed by the additional SE tax. 

[SeattleCPA]

So now you have me wondering if I'm doing this right. Are we required to draw a salary from a side business in order to use a 401k?  I assumed since it is pass-thru income that it was possible to put all the profits into a 401k (so far always less than 30k/yr-and 50/50 partnership- no employees).  Or is this the same as saying my salary was 15k and I deferred the entirety to my 401k?

Presuming 30k business profits:

If you elect to be taxed as a LLC (schedule C), then you can contribute 18k plus 20% of the total profit. (24k in total)

If you elect to be taxed as a S Corp (K-1), then you can contribute 18K -or the total of your W2 salary if <18K- plus 25% of that salary. (18.75k in total if you drew a 15k salary)

But the LLC person who works for the LLC has to pay self employment tax on the entire amount, correct?

Yes, if the LLC has not made an election to be treated as a corporation or S corporation.

[SeattleCPA]

For what it's worth...

I've done the calculations hundreds of times for different client situations... and almost, almost always the numbers don't support a higher salary for higher pension fund contributions. But the math gets tedious. Some things you want to model:

1. The 2.9% or 3.8% Medicare and Obamacare tax burden (and deduction).
2. State payroll taxes... and state S corporation franchise taxes as well.
3. The true benefit of the deferral... I.e., you may get a 25% tax savings when you put money into the plan but then need to remember you may pay 15% when you take the money out.
4. The loss of the preferential tax treatment you would have received on the income if you'd invested same sum in a taxable but tax efficient container.
5. Current and future costs of the pension plan... E.g., the permanency requirement mentioned above.

One wants to be careful about applying general rules to specific situations. But I think the best general rule is set you S corp salary to the lowest reasonable level you can.

P.S. We may have different senses about what you can set your S corporation salary level too...

Every time you post you upset my assumptions!

So, assume $200K in business income after expenses for S Corp.  Pay self $50k in wages.  Of that $50k, you put $24k in salary deferral into 401(k) (because 50 years old or over).   That leaves $26k.  You can also match another $12,500, so $36,500 into the 401(k).

Self employment taxes on the $50k.

Income tax only on the $150k and the $26k wages left over after the salary deferral to the 401(k).

Plus $12,000 or so health insurance premiums deductible as a business expense but gets added to your W-2 (is that taxed?)

Am I thinking clearly on this?

I think so. The thinking clearly, I mean.

Here's how your $50K wages out of $200K of profits thing works...

First, you pay payroll taxes on the $50K... and out of that, yup, you can do $24K for the shareholder-employee's elective deferral.

Then, the other part...

Well, that $12K of health insurance counts as wages. So it means your box 1 W-2 shows $62K. Which means that the employer's match equals $15,500. 25% of the $62K in other words.

Note that you will not pay payroll taxes on the $12K of health insurance. And if you do your 1040 right, you will not pay income taxes on it either. But it bumps up your compensation, bumps up your employer match, and thumps down your distributions.

BTW, not saying you should do this... but if you paid your shareholder-employee $60K in wages... and then $12K in health insurance ... and then did a 25% match (so that's $18K), your total compensation package for the guy is going to be $90K.. the S corporatoin distributive share will be $110K roughly. And that might be reasonable for many situations. Even though you're only paying SE taxes on $60K and are actually saving about $13K.

Note: The last tax court case on this was a CPA named David Watson (google-able) and he got court to agree to $90K in wages and $140K in distributive share.

[Malum Prohibitum]

Wow, thanks SeattleCPA.  That last post did not just confirm what I wrote but added very valuable information.  I am actually printing it out.

[Malum Prohibitum]

Note: The last tax court case on this was a CPA named David Watson (google-able) and he got court to agree to $90K in wages and $140K in distributive share.

  http://media.ca8.uscourts.gov/opndir/12/02/111589P.pdf

[Malum Prohibitum]

Note: The last tax court case on this was a CPA named David Watson (google-able) and he got court to agree to $90K in wages and $140K in distributive share.

  http://media.ca8.uscourts.gov/opndir/12/02/111589P.pdf

  A little scary to note in the one person S Corp situation the court seems of the opinion that everything is wages . . . see the last two pages.  Oddly, they did not attempt to apply that to his corporation inside of the corporation, content rather to just affirm the trial court.

[SeattleCPA]

Watson used an S corporation as the entity through which to own his interest in the partnership. I.e., rather than own his partnership interest directly, he owned an S corporation which owned his partnership interest in the CPA firm.

My caveat: I think you need to be especially careful with  the single shareholder, single employee situation. But you can pull out the Watson case to show court doesn't necessarily think that arrangement is bogus.

Another *really* important thing to note is that a few years ago, Congress discussed this very issue.. whether you could have these small one and two and three man S corporations run the gambit we're talking about. ( This is really significant because Congress makes the rules. )

So House of Representatives passed a new law, HR 4213, that said, "Heck yeah, we want to prohibit small S corps from doing this -- if they're white collar type businesses. Now, blue collar guys? No problem with the plumber or the electrician... That's fine. But an accountant or engineer etc? No way..."

Short story: Senate took a look at this and pointed out the obvious inequity and killed the bill.

Even more details here: http://www.scorporationsexplained.com/what-is-a-disqualified-S-corporation.htm

[Malum Prohibitum]

Watson used an S corporation as the entity through which to own his interest in the partnership. I.e., rather than own his partnership interest directly, he owned an S corporation which owned his partnership interest in the CPA firm.

My caveat: I think you need to be especially careful with  the single shareholder, single employee situation. But you can pull out the Watson case to show court doesn't necessarily think that arrangement is bogus.

Another *really* important thing to note is that a few years ago, Congress discussed this very issue.. whether you could have these small one and two and three man S corporations run the gambit we're talking about. ( This is really significant because Congress makes the rules. )

So House of Representatives passed a new law, HR 4213, that said, "Heck yeah, we want to prohibit small S corps from doing this -- if they're white collar type businesses. Now, blue collar guys? No problem with the plumber or the electrician... That's fine. But an accountant or engineer etc? No way..."

Short story: Senate took a look at this and pointed out the obvious inequity and killed the bill.

Even more details here: http://www.scorporationsexplained.com/what-is-a-disqualified-S-corporation.htm

  I remember that!  And that was the last year Democrats controlled the House!  Thankfully some of the more centrist Democrats in the Senate sided with the Republicans to kill that bill.  The political winds may change, however, and when Democrats are in power again they may see this as a useful step toward partially bridging the deficit that both parties seem content to keep running every year. 

Biting nails

[wearfannypacks]

Roughly (roughly) with $62K of sole proprietorship profits, someone could do $18K plus another $12K (20% of the $62K) or $30K in total.

If this is a partnership with two partners (spouses say) they could do $18K plus $18K plus another $12K, so $48K in total.

BTW if you're an S corporation making $62K, that $62K doesn't matter. (Hopefully you're not because it wouldn't make sense in your situation probably.) But in this situation, you can do the greater of 100% of your W-2 wages plus 25% of your W-2 wages. E.g., if $20K of the $62K is wages, you can do $18K plus another $5K.

BTW, some of the employer percentages are 20% and some are 25%... but it turns out those are the same numbers. Basically. The 20% can also be described as 25% after the 25%... which is the same thing as 20%. Pretty much.

E.g. and making the math easy, if your sole proprietorship made $125K a year, you could contribute roughly 20% of $125K or $25K. But that 25K is $25% of the $125K business profit after you've subtracted the $25K match.

Wow, such great information. Thanks for explaining the math. I appreciate all the specific details. I'm the sole shareholder in a PLLC (no s-corp election.) With my spouses income we will be in the 33% tax bracket next year. An additional 18k in contributions saves us 6k in taxes this year.

How does adding a spouse to the solo 401k work? Do they have to be a shareholder? Would I have to pay his FICA before we could contribute? I guess that might all even out because I pay FICA on it all anyway. It would just be technically split between the 2 of us. I'd love to reduce our tax burden as much as possible because we are at the peak of our taxable income in these years.

I would caution you about a 401(k) plan if you have employees. I did see that currently neither employee qualifies... but if that changes in future, you're going to run into lots of increased costs once you upgrade your 401(k) plan to handle more than just you...

The big issue, I think, is the permanency requirement, as discussed in more detail about half way down this blog post:

http://evergreensmallbusiness.com/hidden-small-business-pension-plan-costs/

For what it's worth, I would love to personally MAX my accounts too. But because I work with employees in my CPA firm and no one else on team values the higher elective deferral limits of a 401(k) as compared to a Simple-IRA plan, we use a Simple-IRA plan.

I.e., it just doesn't pencil out to pay $2K, $3K or $4K annually to move your elective deferral from $12.5K to $18K or from $15.5K to $24K.

Ya, I hear what you are saying. Those are good questions to consider. I don't believe I was to expand. I like my small-part time, leave on vacation whenever my husband has off kind of practice. I also hadn't considered the permancy clause. Lemme type out my thoughts as I review. My business is a little unusual. If I'm busy enough to need to contribute to employee 401k, I will gladly match them. They are entry level hourly rate. I imagine my salary would increase so I'd be maxing out the 401k and the 2-6k admin fees are lower than my tax benefit. My total employee hours last month were 28 hours. Last year I had 210 hours total between 3 very part-time employees who are college students I pay $10 an hour. If I was my own employee, I probably wouldn't qualify for 1000 working hours a year. I don't have a desire to expand. I'm planning on selling or passing on my practice to someone else when I'm ready to FIRE.

Just to respond to the phase I boldfaced in your message... it is very hard to justify spending admin fees on the basis of a higher tax deferral. One wants to be careful to remember the tax deferral benefit gets "reversed" later on... and those admin fees are gone forever.

I hear what you are saying about tax deferral being reversed later on. Our MFJ income is in the neighborhood of 500-700k this year. Our income is at it's highest right now. When we retire, we will be living on waaaaay less than that. I would rather arbitrage tax savings now and pay the lower tax rate upon withdraw during FIRE. In response to the being willing to pay the admin fees. My practice revenue would be 5-10x what it is now, if I had an employee who qualified for my 401k. The extra 2-6k would be a drop in the bucket.

[Gumption]

I am an S corp and used SEP IRA for years. What is more efficient as far as putting pre tax money in investments is getting an individual 401(k). As long as you don't have employees (other than spouse, if necessary) 25% employee match + 18k employee contributions. Guessing you might have your own high ded. health plan as well. so you and your spouse can contribute/invest $6750. into that as well.

Here is what we do. Does anyone have any additional places to put money?
401k Employee: $18,000
401 Employer: 25%
HSA: $6750.
Spouse IRA: $5500.

[Malum Prohibitum]

My practice revenue would be 5-10x what it is now, if I had an employee who qualified for my 401k.

Sounds like a no brainer, then, wearfannypacks.

[SeattleCPA]

I am an S corp and used SEP IRA for years. What is more efficient as far as putting pre tax money in investments is getting an individual 401(k). As long as you don't have employees (other than spouse, if necessary) 25% employee match + 18k employee contributions. Guessing you might have your own high ded. health plan as well. so you and your spouse can contribute/invest $6750. into that as well.

Here is what we do. Does anyone have any additional places to put money?
401k Employee: $18,000
401 Employer: 25%
HSA: $6750.
Spouse IRA: $5500.

I agree that throwing in an elective deferral works...

BTW, Gumption, some people would do something like I show below.. BTW I'm going to arbitrarily say your S corp makes $100K..

So you'd pay Mr. Gumption a base wage of $24K... plus throw in family HDHP of $6K a year... plus HSA of $6750 a year... so though Mr. Gumption  only pays payroll taxes on $24K, his W-2 Box 1 equals $36,750 and S corp can make a 25% or $9187.50 employer match.

Ms. Gumption works part-time, but her contribution is key to organization's success so she would also get a wage of $24K out of which she gets $18K elective deferral and then a $6K employer match.

BTW, out of the original $100K (per my example), there's still another $20K leftover and this gets distributed to Gumption shareholder and is subject to income taxes.

But tally up the taxes and look at the deferrals: Though you made $100K (per the example), you only paid payroll taxes on $48K and paid income taxes on roughly $36K...

P.S. I was a little rough in my calculations... E.g., I didn't model the tax deduction from the employers share of the payroll taxes. But hopefully you see the point.

[SeattleCPA]

My practice revenue would be 5-10x what it is now, if I had an employee who qualified for my 401k.

Sounds like a no brainer, then, wearfannypacks.

I think maybe we're conflating three issues here.

One is, if wearfunnypacks makes a gajillion, $4K in admin fees isn't very significant. BTW, totally agree with that.

Another issue is, does it make sense to pay $4K a year in admin fees to bump the elective deferral from $12.5K to $18K or from $15.5K to $24K. This, I'm still going to argue, doesn't make financial sense.

The third issue: The $4K in admin fees issues can probably be ignored if chance they're relevant is very small. I.e., agree there's not need to worry about 5% chance of a $4K annual fee.

[Malum Prohibitum]

Oh, I just meant it was a no brainer to hire somebody if revenue would increase by 5 or 10 multiples . . .

[mamagoose]

What about hiring your spouse and paying them 18000 that they put into the i401k (spousal 401k I think it's called) plus 25% employer match?

[Malum Prohibitum]

What about hiring your spouse and paying them 18000 that they put into the i401k (spousal 401k I think it's called) plus 25% employer match?

  You then have to pay the payroll taxes (both sides, one half taken from your wife's check and the other half paid by you as the employer) on that $18,000.  The 25% would be without payroll or income tax.

[Gumption]

I am an S corp and used SEP IRA for years. What is more efficient as far as putting pre tax money in investments is getting an individual 401(k). As long as you don't have employees (other than spouse, if necessary) 25% employee match + 18k employee contributions. Guessing you might have your own high ded. health plan as well. so you and your spouse can contribute/invest $6750. into that as well.

Here is what we do. Does anyone have any additional places to put money?
401k Employee: $18,000
401 Employer: 25%
HSA: $6750.
Spouse IRA: $5500.

I agree that throwing in an elective deferral works...

BTW, Gumption, some people would do something like I show below.. BTW I'm going to arbitrarily say your S corp makes $100K..

So you'd pay Mr. Gumption a base wage of $24K... plus throw in family HDHP of $6K a year... plus HSA of $6750 a year... so though Mr. Gumption  only pays payroll taxes on $24K, his W-2 Box 1 equals $36,750 and S corp can make a 25% or $9187.50 employer match.

Ms. Gumption works part-time, but her contribution is key to organization's success so she would also get a wage of $24K out of which she gets $18K elective deferral and then a $6K employer match.

BTW, out of the original $100K (per my example), there's still another $20K leftover and this gets distributed to Gumption shareholder and is subject to income taxes.

But tally up the taxes and look at the deferrals: Though you made $100K (per the example), you only paid payroll taxes on $48K and paid income taxes on roughly $36K...

P.S. I was a little rough in my calculations... E.g., I didn't model the tax deduction from the employers share of the payroll taxes. But hopefully you see the point.

SeattleCPA. I have been taking HDHP and HSA out on the personal side of my return. If you do these on the Biz side are they just considered Business Expenses, or how do you categorize them? HDHP and HSA (12k, 6,750 a year for me) are then added to my salary but not taxed? Please enlighten me :-) your input is appreciated. BTW, I have decided not to hire spouse to get the 18k 401k contribution as w2 tax seems to cancel that benefit out.

[SeattleCPA]

I am an S corp and used SEP IRA for years. What is more efficient as far as putting pre tax money in investments is getting an individual 401(k). As long as you don't have employees (other than spouse, if necessary) 25% employee match + 18k employee contributions. Guessing you might have your own high ded. health plan as well. so you and your spouse can contribute/invest $6750. into that as well.

Here is what we do. Does anyone have any additional places to put money?
401k Employee: $18,000
401 Employer: 25%
HSA: $6750.
Spouse IRA: $5500.

I agree that throwing in an elective deferral works...

BTW, Gumption, some people would do something like I show below.. BTW I'm going to arbitrarily say your S corp makes $100K..

So you'd pay Mr. Gumption a base wage of $24K... plus throw in family HDHP of $6K a year... plus HSA of $6750 a year... so though Mr. Gumption  only pays payroll taxes on $24K, his W-2 Box 1 equals $36,750 and S corp can make a 25% or $9187.50 employer match.

Ms. Gumption works part-time, but her contribution is key to organization's success so she would also get a wage of $24K out of which she gets $18K elective deferral and then a $6K employer match.

BTW, out of the original $100K (per my example), there's still another $20K leftover and this gets distributed to Gumption shareholder and is subject to income taxes.

But tally up the taxes and look at the deferrals: Though you made $100K (per the example), you only paid payroll taxes on $48K and paid income taxes on roughly $36K...

P.S. I was a little rough in my calculations... E.g., I didn't model the tax deduction from the employers share of the payroll taxes. But hopefully you see the point.

SeattleCPA. I have been taking HDHP and HSA out on the personal side of my return. If you do these on the Biz side are they just considered Business Expenses, or how do you categorize them? HDHP and HSA (12k, 6,750 a year for me) are then added to my salary but not taxed? Please enlighten me :-) your input is appreciated. BTW, I have decided not to hire spouse to get the 18k 401k contribution as w2 tax seems to cancel that benefit out.

You have been doing this at least partially wrong. First, to get the self-employed health insurance deduction, you are required to include the HDHP amount in your W-2 box 1 earnings... but not in Box 3 or Box 5...

Then you take out the HDHP amount as self-employed health insurance on your 1040. This means in end HDHP saves you income taxes and SE taxes...

I believe you'd lose the HDHP deduction if you're audited.

BTW, you should be able to treat HSA the same way...

And then another benefit of doing this the right way is that your HDHP and HSA now bump up your employer's profit sharing match...

Can I point something out? People absolutely should turbotax their own simple 1040s... but the 1120S return is too complicated to DIY. People always miss stuff.

[Gumption]

Company contributions to HDHP and HSA are still subject to federal withholding, correct?
They are just exempt from FICA as far as I can tell.

[GetSmart]

So now you have me wondering if I'm doing this right. Are we required to draw a salary from a side business in order to use a 401k?  I assumed since it is pass-thru income that it was possible to put all the profits into a 401k (so far always less than 30k/yr-and 50/50 partnership- no employees).  Or is this the same as saying my salary was 15k and I deferred the entirety to my 401k?

Presuming 30k business profits:

If you elect to be taxed as a LLC (schedule C), then you can contribute 18k plus 20% of the total profit. (24k in total)

If you elect to be taxed as a S Corp (K-1), then you can contribute 18K -or the total of your W2 salary if <18K- plus 25% of that salary. (18.75k in total if you drew a 15k salary)

Is it not possible to contribute to a 401k without creating a real paycheck?  The income from one of my businesses is so small that I could never find an option to create a paycheck that didn't cost $50/mo. so the contribution was made directly.  Now there seems to be no way of showing this on the tax return?  My acct. has been showing this as a deduction on Line 28 but I never thought that was correct - he's now telling me it's limited to a small amount.  Hoping Seattle CPA or someone can weigh in on this.  Yet being self-employed I still have to pay SE taxes on the total income before 401k contribution? So where does it all go on the tax return?

[Malum Prohibitum]

Getsmart, you are a partnership, right?  Then the entire amount is your paycheck.  Having W-2 compensation does not necessarily mean hiring a payroll company at $50 monthly.

[tralfamadorian]

Is it not possible to contribute to a 401k without creating a real paycheck?  The income from one of my businesses is so small that I could never find an option to create a paycheck that didn't cost $50/mo. so the contribution was made directly.  Now there seems to be no way of showing this on the tax return?  My acct. has been showing this as a deduction on Line 28 but I never thought that was correct - he's now telling me it's limited to a small amount.  Hoping Seattle CPA or someone can weigh in on this.

If you elect for your business to be taxed as a LLC, then you don't do a paycheck/payroll, your profits are shown on a schedule C and your se401k deductions are shown on line 28.  Regarding your CPA saying your contribution being limited- do you have another 401k at a different job?  Or was the profit of this business smaller than the contribution?

Yet being self-employed I still have to pay SE taxes on the total income before 401k contribution? So where does it all go on the tax return?

Unfortunately, yes, SE taxes are paid on your whole schedule C profit.  Even with a W2 job, you pay social security and medicare taxes on your full compensation including 401k contributions.  Pre-tax 401k contributions let you avoid income tax.  The most common way to avoid SE tax on all your business profits for a small business is with a S corp but it doesn't sound like this business is at the profitability level where a S corp would make sense.  Your SE tax is listed on the 2nd page of your 1040 under "other taxes" line 57.

[SeattleCPA]

Company contributions to HDHP and HSA are still subject to federal withholding, correct?
They are just exempt from FICA as far as I can tell.

I don't think you're do federal withholding on HDHP or HSA because accounted for correctly these amounts shouldn't be subject to federal income taxes.

[GetSmart]

Edited to say:  In doing some research I found the answer to my own questions.

And also found this on Bogleheads from 2015 so numbers are out of date:

Sole proprietors/Schedule C: all pension contributions (401k, SEP, SIMPLE) must be entered on 1040, Line 28, NOT Schedule C, Line 19. The net result is that the pension contributions are subject to FICA, self-employment taxes, mentioned above. You do get a little of this back with on 1040, Line 27 but this is a "deduction" NOT a "credit".

Corporations (S Corp, C Corp): If you incorporate, all EMPLOYER pension contributions are EXEMPT FROM INCOME AND FICA. These contributions are deducted from your corporate income and never subjected to payroll taxes. So, from the perspective of minimizing payroll taxes, for the self-employed, it is best to incorporate and maximize employer pension contributions and minimize salary deductions (employee contributions).

So, how do I put it all together?? I live in California and use an S Corp. My goal was to put $52K in my 401k. I paid myself a "reasonable salary" of $138k. This allowed for a employer 401k contribution of $34.5k and deducted it on 1120S. Income left over after corporate deductions and salary deductions, I take as a shareholder distribution on my K1. I made $17.5K 401k contributions as salary deductions. Net result, I paid FICA on my W2 and $17.5K 401k contribution. I only pay income tax (NO FICA) on shareholder distributions. No taxes paid on $31.5k (deferred).

Wish I had realized this last week - it would have saved me a bit on SE taxes. :(