Deductions for employer contributions to defined contribution plans are ordinarily limited to 25 percent of the participants’ aggregate compensation, but that limitation doesn’t apply to contributions to 401(k) plans made as a result of participants’ elective deferrals. That provision is of little interest to most employers, but it is highly beneficial to self-employed individuals with relatively small self-employment earnings. They can often put a much larger part of those earning aside for retirement by setting up a “solo 401(k)” plan than would be possible through an IRA or a conventional profit sharing plan.
Consider, for instance, a lawyer who writes a modestly successful crime novel on the side and garners $40,000 in royalties. He doesn’t need that money for current expenses and would like to stash as much as possible into a tax-deferred vehicle. He will think first of an individual retirement account, but contributions are limited to $6,500 plus an extra $1,000 if he is age 50 or older (2023 limits; the first is indexed, and the second will be after 2023). Moreover, if he is an active participant in a qualified plan (his law firm’s, for instance), he won’t be able to deduct any IRA contributions, and his adjusted gross income may be too high to allow him to make nondeductible contributions to a Roth IRA.
He can do slightly better with a profit sharing plan. Deductible contributions are limited to 25 percent of his net earnings from self-employment after subtracting the contribution itself from earnings. He therefore can contribute and deduct $8,000 (25 percent of ($40,000 - $8,000)).
Suppose, though, that he establishes a 401(k) plan for his trade or business of novel writing. The 2023 limitation on elective deferrals is $22,500, plus an extra $7,500 if he is at least 50 years old on December 31, 2023. Because there is no limitation on deductions, he can deduct the full $30,000 from his self-employment income. The conditions are that he must make his deferral election no later than December 31st and must contribute the amount deferred to the plan by the due date, including extensions, of his federal income tax return.
SECURE Act 2.0 relaxed those conditions in one respect: In the first year of a 401(k) plan of a sole proprietorship that has no employees other than the owner, the deferral election may be made as late as the unextended tax return due date. Hence, our lawyer-author could establish his plan, make a deferral election at any time up to April 15, 2024, and deduct the deferral on his 2023 tax return.
N.B.: The new law is effective for plan years that begin after December 29, 2022, so it doesn’t help someone who had self-employment income in 2022 and didn’t make a deferral election by the end of that year.
References: Pub. Law No. 117-328, Div. T, §317; IRC §401(b)(2), as amended
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