Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

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Messner8000
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Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Messner8000 »

I’m hoping this great community can help me find an answer to this vexing question!

My wife has a small business; it’s a sole proprietorship – she is the only person. We set up a solo 401(k) with Vanguard. My understanding was that my wife can make two retirement account contributions each year – one as the “employee” and one as the “employer.” Accordingly, we made a 2022 employee-side contribution.


What I am trying to do is find authority (an IRS bulletin?) that says that this was okay. The problem is that the IRS bulletins I’m aware of talk about employee-side contributions from “salary deferrals” and “wages.” But my wife doesn’t have any "wages" (e.g., she doesn’t get a W2) or a “salary” per se. She takes in her business’s revenue, and wants to use some of that revenue for an employee-side retirement contribution. I think this is permissible, but I’m not sure what IRS bulletin says so. Any ideas?

I asked Vanguard, who said to ask my CPA. I asked my CPA, who said to ask Vanguard. Help!

Thanks!
JBTX
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by JBTX »

Messner8000 wrote: Wed Mar 22, 2023 3:49 pm I’m hoping this great community can help me find an answer to this vexing question!

My wife has a small business; it’s a sole proprietorship – she is the only person. We set up a solo 401(k) with Vanguard. My understanding was that my wife can make two retirement account contributions each year – one as the “employee” and one as the “employer.” Accordingly, we made a 2022 employee-side contribution.


What I am trying to do is find authority (an IRS bulletin?) that says that this was okay. The problem is that the IRS bulletins I’m aware of talk about employee-side contributions from “salary deferrals” and “wages.” But my wife doesn’t have any "wages" (e.g., she doesn’t get a W2) or a “salary” per se. She takes in her business’s revenue, and wants to use some of that revenue for an employee-side retirement contribution. I think this is permissible, but I’m not sure what IRS bulletin says so. Any ideas?

I asked Vanguard, who said to ask my CPA. I asked my CPA, who said to ask Vanguard. Help!

Thanks!
For a sole prop you don’t have to pay yourself a salary or wages. Your business income will be the basis of income of what you can contribute to your solo 401k.

There could be times and completely non related reasons where it may make sense to pay yourself a salary, but that is a different discussion.
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Artful Dodger
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Artful Dodger »

I'm not a CPA, but to my knowledge contributions (deferrals) come from earned compensation. The most common way to do this is via a salary (with employee and employer FICA share). The "employee" share cannot come directly from (or instead of) distributions.

As I said, not a CPA, but this is my understanding.
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Tamarind
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Tamarind »

Messner8000 wrote: Wed Mar 22, 2023 3:49 pm I’m hoping this great community can help me find an answer to this vexing question!

My wife has a small business; it’s a sole proprietorship – she is the only person. We set up a solo 401(k) with Vanguard. My understanding was that my wife can make two retirement account contributions each year – one as the “employee” and one as the “employer.” Accordingly, we made a 2022 employee-side contribution.


What I am trying to do is find authority (an IRS bulletin?) that says that this was okay. The problem is that the IRS bulletins I’m aware of talk about employee-side contributions from “salary deferrals” and “wages.” But my wife doesn’t have any "wages" (e.g., she doesn’t get a W2) or a “salary” per se. She takes in her business’s revenue, and wants to use some of that revenue for an employee-side retirement contribution. I think this is permissible, but I’m not sure what IRS bulletin says so. Any ideas?

I asked Vanguard, who said to ask my CPA. I asked my CPA, who said to ask Vanguard. Help!

Thanks!
https://www.irs.gov/retirement-plans/on ... 401k-plans

As a sole proprietor, your wife's "net earnings from self-employment" is the starting point for calculating her allowable 401k contribution. This is slightly less than her business's revenue less its costs, as it also adjusts for the deductible part of SE tax

Here's the detailed definition: https://www.irs.gov/publications/p560#e ... nk10008810

In Publication 560, read the section for Qualified Plans, which is what a solo 401k is, except wherever it reads "compensation" think "net earnings from self employment".

Then scroll on down and find the Deduction Worksheet for Self-Employed. This will take you through the exact math. To complete this worksheet, you need to have have done your tax return Schedules C and SE (or a draft return if you are guessing mid year).
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Tamarind
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Tamarind »

Artful Dodger wrote: Wed Mar 22, 2023 4:19 pm I'm not a CPA, but to my knowledge contributions (deferrals) come from earned compensation. The most common way to do this is via a salary (with employee and employer FICA share). The "employee" share cannot come directly from (or instead of) distributions.

As I said, not a CPA, but this is my understanding.
This is not relevant for a sole proprietorship, since all net income of the business ends up in Schedule C, and the tax is calculated on Schedule SE and paid as estimated income tax rather than payroll withholdings.

Vanguard can't give OP tax advice, but it sounds like OP's wife needs a better CPA who actually has experiences with small businesses.
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Tamarind
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Tamarind »

Artful Dodger wrote: Wed Mar 22, 2023 4:22 pm Here's a helpful (or maybe not so helpful) IRS FAQ...

https://www.irs.gov/retirement-plans/re ... tributions
This is for S-corps, not sole proprietorships
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Artful Dodger
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Artful Dodger »

Sorry, I totally misread. You're a sole prop, not an S-Corp. Assuming you're filing a schedule C, once you remove any eligible expenses, what is left is your earned income, and you can make an employee contribution from that. She would owe the SE tax on the earned income.
sailaway
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by sailaway »

Turbo Tax said I could, if that constitutes enough authority for you.
runner3081
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by runner3081 »

I found these calculators to be very helpful. Makes it easy :)

https://bcmadvisors.com/solo-401k-calculator/

Also this one.
https://www.solo401k.com/calculator/
peteyboy
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by peteyboy »

Your wife's sole proprietorship needs to have profit in order for her to make contributions to the s401k, as the employee or employer. This profit is the earned income that is used to determine the max amount that can be contributed to the s401k. Most all of the time there is no W-2 involved. In some instances 1099-NEC income is involved. The sole proprietorship is a disregarded passthrough entity, thus its profit (earned income) is taxed on your US income tax filing.

Fill out Schedule C - this is where one take deductions for the cost of running the business and determines the net profit. If no profit, then no s401k deferral. Next, one fills out Schedule SE. Finally, one uses the info on Schedules C & SE to fill our Schedules 1 & 2. On Schedule 1, line 16 is where you add the total s401k deferrals made (by both employee and employer).

If you want to find out how much can go in to the s401k based on the sole proprietorship's profit, this calculator can help: https://obliviousinvestor.com/solo-401k ... alculator/
Last edited by peteyboy on Wed Mar 22, 2023 5:29 pm, edited 1 time in total.
peteyboy
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by peteyboy »

Messner8000 wrote: Wed Mar 22, 2023 3:49 pm ...We set up a solo 401(k) with Vanguard. My understanding was that my wife can make two retirement account contributions each year – one as the “employee” and one as the “employer.” Accordingly, we made a 2022 employee-side contribution.
One more thing....Perhaps one of the previous responders commented, but I will as well. You can make as many contributions during the year as you want, as employee or employer. If there is a limit as to the number of contributions during the year, that is a limit imposed by the provider, not the IRS. Vanguard doesn't have a limit as far as I know. I have a s401k set up at Vanguard and for the 2022 tax year I make a total of four contributions, all as the employee - and one was in Feb 2023.
fyre4ce
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by fyre4ce »

Check out the table on Page 34 of IRS Pub 560. I believe it has the calculation you're looking for. In short, it doesn't technically distinguish between "employee" and "employer" contributions, but it does allow the business owner to make an elective deferral and then additional contributions on top of that, so the math works out to be basically the same.
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David Jay
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by David Jay »

Also note that her income can be used for your contributions through the spousal rule. You could open a tIRA and a Roth and perform the backdoor Roth process each year.
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Messner8000
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Messner8000 »

Wow - thanks for all the responses. I think I'm getting closer!
fyre4ce wrote: Wed Mar 22, 2023 7:58 pm Check out the table on Page 34 of IRS Pub 560. I believe it has the calculation you're looking for. In short, it doesn't technically distinguish between "employee" and "employer" contributions, but it does allow the business owner to make an elective deferral and then additional contributions on top of that, so the math works out to be basically the same.
The table on page 34 is titled "deduction worksheet for self-employed" and says as one of the entries: "Enter your allowable elective deferrals (including designated Roth contributions) made to your self-employed plan for the 2022 plan year. Don't enter more than $20,500"

So this begs the question, what is an "allowable elective deferral." Well, that term is not defined. However, "Elective deferral" is defined:

"Elective Deferral" is defined as: Elective deferral. An elective deferral is the contribution
made by employees to a qualified retirement plan.
•Non-owner employees: The employee salary reduction/elective deferral contributions must be elected/
made by the end of the tax year and deposited into
the employee’s plan account within 7 business days
(safe harbor) and no later than 15 days.
•Owner/employees: The employee deferrals must be
elected by the end of the tax year and can then be
made by the tax return filing deadline, including extensions.

So is it fair to assume that since my wife is an owner/employee. and has a qualified retirement plan, under this guidance she could make an employee elective deferral of up to $20,500?
peteyboy
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by peteyboy »

Messner8000 wrote: Wed Mar 22, 2023 8:29 pm
So is it fair to assume that since my wife is an owner/employee. and has a qualified retirement plan, under this guidance she could make an employee elective deferral of up to $20,500?
She could if she had sufficient profit (earned income) from the sole proprietorship.
fyre4ce
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by fyre4ce »

Messner8000 wrote: Wed Mar 22, 2023 8:29 pm Wow - thanks for all the responses. I think I'm getting closer!
fyre4ce wrote: Wed Mar 22, 2023 7:58 pm Check out the table on Page 34 of IRS Pub 560. I believe it has the calculation you're looking for. In short, it doesn't technically distinguish between "employee" and "employer" contributions, but it does allow the business owner to make an elective deferral and then additional contributions on top of that, so the math works out to be basically the same.
The table on page 34 is titled "deduction worksheet for self-employed" and says as one of the entries: "Enter your allowable elective deferrals (including designated Roth contributions) made to your self-employed plan for the 2022 plan year. Don't enter more than $20,500"

So this begs the question, what is an "allowable elective deferral." Well, that term is not defined. However, "Elective deferral" is defined:

"Elective Deferral" is defined as: Elective deferral. An elective deferral is the contribution
made by employees to a qualified retirement plan.
•Non-owner employees: The employee salary reduction/elective deferral contributions must be elected/
made by the end of the tax year and deposited into
the employee’s plan account within 7 business days
(safe harbor) and no later than 15 days.
•Owner/employees: The employee deferrals must be
elected by the end of the tax year and can then be
made by the tax return filing deadline, including extensions.

So is it fair to assume that since my wife is an owner/employee. and has a qualified retirement plan, under this guidance she could make an employee elective deferral of up to $20,500?
"Elective deferral" is the technical term for the employee 401k limit, which is $20,500 in 2022 and $22,500 in 2023 (not counting any catch-up contributions for age 50+). Each person only gets one elective deferral limit per year, regardless of how many jobs they have. Let's say your wife also worked a W-2 job and had access to a 401k with a match. In that case, it would be best to use the elective deferral at work and get the match, and it wouldn't be available to use in her sole proprietorship. With that excluded for the calculation, she could contribute 20% of her net business profit only.

It sounds like she doesn't have another job, so her full elective deferral is available to use in her sole proprietorship. In effect, this means the first $22,500 of business earnings could all be contributed to a solo 401k if she chooses. Above that, a percentage of additional earnings can also be contributed (the calculation is run per that worksheet I linked), up to the total per-plan limit of $61,000 in 2022 and $66,000 in 2023.

Hope that helps.
Luckywon
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Luckywon »

If the net earnings from your wife's business are greater than the elective deferral limit, you should consider doing "megabackdoor Roth contributions". However, she would need a 401k plan that permits them (the one she has at Vanguard will not). These are many discussions online about how to establish a solo 401k plan which permits MBR.
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Tamarind
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Tamarind »

OP, it may help us guide you to know (roughly) how much your wife made from her business last year. The value that starts the calculation is line 31 of schedule C.

To be allowable, your wife's contribution as an employee must be less than than that value less the deductible SE tax (~92.5% of line 31) and also less than $20,500 (for 2022). That means she needed to make around $23k in profit to max out the employee contribution. She also must not break any of the rules for a qualified one-participant plan - i.e she must follow the rules in her plan document (the big packet she signed w Vanguard), she may not have any other employees working in the business, and so on.
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Messner8000
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Messner8000 »

peteyboy wrote: Wed Mar 22, 2023 8:44 pm
Messner8000 wrote: Wed Mar 22, 2023 8:29 pm
So is it fair to assume that since my wife is an owner/employee. and has a qualified retirement plan, under this guidance she could make an employee elective deferral of up to $20,500?
She could if she had sufficient profit (earned income) from the sole proprietorship.
So there is anything that says "earned income" can be used for the employee-side i401k contribution?

Let's pick a round number and say for purposes of our discussion that she made $100,000 last year. I just am looking for a cite that says last year it was okay to take $20,500 of this and put it in a i401k as an employee side contribution. (I realize there is a formula for the employer-side contribution, and our CPA handles that calculation for us).
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Messner8000
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Messner8000 »

Or perhaps stating the same question a different way (and I hope I'm saying this right), is there something that says that income/profit reported only on a schedule C (not a W-2) can be used for the employee-side contribution to an i401k for sole prop.
txgolfer_19
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by txgolfer_19 »

Yes, Tamarind gave you the IRS link in his first post.
peteyboy
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by peteyboy »

Messner8000 wrote: Thu Mar 23, 2023 5:44 am
peteyboy wrote: Wed Mar 22, 2023 8:44 pm
Messner8000 wrote: Wed Mar 22, 2023 8:29 pm
So is it fair to assume that since my wife is an owner/employee. and has a qualified retirement plan, under this guidance she could make an employee elective deferral of up to $20,500?
She could if she had sufficient profit (earned income) from the sole proprietorship.
So there is anything that says "earned income" can be used for the employee-side i401k contribution?

Let's pick a round number and say for purposes of our discussion that she made $100,000 last year. I just am looking for a cite that says last year it was okay to take $20,500 of this and put it in a i401k as an employee side contribution. (I realize there is a formula for the employer-side contribution, and our CPA handles that calculation for us).
Or perhaps stating the same question a different way (and I hope I'm saying this right), is there something that says that income/profit reported only on a schedule C (not a W-2) can be used for the employee-side contribution to an i401k for sole prop.
I think you may be getting hung up on the W-2 not being there to “prove” it’s earned income. If that’s the case, please understand she won’t have a W-2 unless she was to issue herself one - which is not going to happen.

In the case of sole proprietorships where is business is consulting, freelance, or contractor work that generates 1099-NEC income, then that person typically receives that form from the payor of the service.

If she has a business making and selling baked goods, quilts, or furniture, for example, then she will not have 1099-NEC income either. However, she would have gross sales and after all deductions (Schedule C) she would most likely have a net profit. The Schedule C net profit = earned income. Schedule C is the documentation showing her earned income.

If, as in your example, her net profit was $100K in year X, then she could defer the max employee contribution to her s401k for year X (In 2022, the max an employee can contribute to their s401k is $22.5K if under 50 years of age, and it’s $22.5K in 2023). That is unless she had made deferrals to another 401K or a 403b plan she had access to. If that was the case then she would have to take those deferral into accounts.

See this link from the IRS:

https://www.irs.gov/retirement-plans/on ... 401k-plans

Also here is a website devoted to the solo 401k that may be of help:

https://www.mysolo401k.net/solo-401k/so ... and-types/
Last edited by peteyboy on Thu Mar 23, 2023 7:12 am, edited 1 time in total.
Topic Author
Messner8000
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Messner8000 »

Whoops - sorry for the confusion. And I REALLY appreciate all the help. So the link that Tamarind shared (https://www.irs.gov/retirement-plans/on ... 401k-plans) says we can make: "Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit." So that's good! But the example to support this principle discusses "wages." It doesn't explicitly say that "earned income" for a SP can include compensation other than wages. Do you think it is safe to assume that profits are "earned income"?
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Messner8000
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by Messner8000 »

Thanks, Peteyboy, I was typing while you were responding! That response is very helpful. Her income is reported on 1099-K and 1099-MISC forms, so the NEC income issue is not implicated.

You said: The Schedule C net profit = earned income. Schedule C is the documentation showing her earned income.

That's really helpful. So it sounds like Schedule C provides the earned income figure, and under the IRS guidance link you and Tamarind shared your employee elective deferral is a function of earned income, so I should be good to go!
peteyboy
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by peteyboy »

Messner8000 wrote: Thu Mar 23, 2023 7:16 am Thanks, Peteyboy, I was typing while you were responding! That response is very helpful. Her income is reported on 1099-K and 1099-MISC forms, so the NEC income issue is not implicated.

You said: The Schedule C net profit = earned income. Schedule C is the documentation showing her earned income.

That's really helpful. So it sounds like Schedule C provides the earned income figure, and under the IRS guidance link you and Tamarind shared your employee elective deferral is a function of earned income, so I should be good to go!
Awesome! Glad to hear you got it cleared up and have a path toward.
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life in slices
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by life in slices »

OP, I think you are getting there.

Schedule C is going to drive the determination of earned income that is available for a solo-401k
As long as you have documentation of your receivables (income) and your expenses, it is all captured on schedule C
[I also produce an annual income and profit statement for my wife's business as well that summarizes everything]

My wife has a solo401k that I am the administrator for - she has a small business (sole prop) that brings in both cash (Venmo, Paypal, check and physical cash) and via 1099NEC, so my knowledge comes from that

In the end, the way to calculate what you can add into a solo 401k is driven by the calcs we do when we file taxes

The forumula is:

Total Income - total expenses (including mileage expense) = net profit
Net profit * 92.35% * (15.3%/2) = net earnings which would be the max amount you could contribute to a solo 401k (up to the limit of course)
[92.35% is the max of net profit that is subject to the SE tax]
[half of the SE tax of 15.3% is refunded back when you file federal taxes]

One quick point to clarify some comments above

solo401k contributions have to be 'deterministic' and cannot necessarily be adhoc....meaning you have to have a documented contribution statement (e.g. salary reduction statement) on file that determine how and when you contribute money vs. just doing it when and how you want to. It can be as simple as stating on a piece of paper (and signed by your wife) "Contribute 100% of eligible earnings, up to the maximum allowable, in one contribution before taxes are filed", etc....we have something similar, but allows us to make quarterly contributions. Hope that makes sense. Happy to answer any more questions you have
peteyboy
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Re: Help! Can Sole Proprietor with no “wages” make employee-side retirement contributions?

Post by peteyboy »

life in slices wrote: Thu Mar 23, 2023 8:12 am
The forumula is:

Total Income - total expenses (including mileage expense) = net profit
Net profit * 92.35% * (15.3%/2) = net earnings which would be the max amount you could contribute to a solo 401k (up to the limit of course)
[92.35% is the max of net profit that is subject to the SE tax]
[half of the SE tax of 15.3% is refunded back when you file federal taxes]
OP, this is correct and something to keep in mind. Filling out your Schedule SE properly will provide these details (lines 12, 13 Schedule SE). You do have to remove the employer portion of the SE tax from the net profits (Schedule 1, line 3) to determine the amount that can be contributed to the s401k.

Essentially, lines 15 and 16 on Schedule 1, when added together, cannot be greater than your net profit (Schedule 1, line 3) if net profit is below the employee contribution limit. If net profit (minus employer SE tax) is above the employee contribution limit, and you want to make employer contributions, then you need to determine the maximum the employer contributions separately. However, the employer contribution amount will also be included in the amount entered on line 16 (Schedule 1) - this is the sum of the employee and employer contributions in the case of a sole proprietorship (disregarded entity).

I think I posted this previously in this thread but if you want to get an accurate estimate of the amount of that she can put into the s401k based on net profit you can use this calculator: https://obliviousinvestor.com/solo-401k ... alculator/

If you play around with various scenarios in that calculator the things that effect the max s401k contributions (employee and employer) will become clearer.
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