Case of the Week: What is the Maximum Amount a Self-employed Person Can Contribute to an Owner-only 401(k) Plan?

The ERISA consultants at the Columbia Management Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with a financial advisor in Ohio is representative of a common owner-only contribution scenario. The advisor asked:

“What is the maximum contribution my client, who is self-employed and unincorporated, can make to his owner-only 401(k) plan for 2013?”

Highlights of Discussion

• Only your client and his tax advisor can determine the actual contribution he is eligible to make to his 401(k) plan.
• But, generally speaking, the maximum amount a self-employed person may be able to contribute to an owner-only 401(k) would be $51,000 if he or she is under age 50; and $56,500 if he or she is age 50 or older, assuming he or she has self-employment income to support the maximum contribution.
• Some of the contribution will be considered salary deferrals and some will be considered profit sharing.
• Under IRS rules, the maximum employee salary deferral amount allowed for 2013 is $17,500. However, participants who are age 50 or older can make an additional salary deferral contribution of $5,500 as catch-up contributions.
• In general, the maximum deductible contribution a business can make to a 401(k)/profit sharing plan is 25% of the total compensation paid to participants.
• Compensation for plan contribution purposes for a self-employed person is “earned income” up $255,000 for 2013.
• Earned income for a self-employed person is net profit adjusted for: (1) one-half of his self-employment tax; and 92) the profit-sharing contribution, as the following formula demonstrates.

Net Profit — 1/2 self-employment tax
__________________________________________ = Earned Income
1 + profit-sharing contribution percentage

• For sole proprietors, net profit is found by referring to IRS Form 1040, Schedule C; for farmers, net profit is found by referring to IRS Form 1040, Schedule F; and for partners, net profit is found by referring to IRS Form 1065, Schedule K-1.

Conclusion

Depending on a self-employed person’s level of earned income and age, he or she potentially could contribute up to a total of $56,500 into his or her owner-only 401(k) plan for 2013, of which $17,500 would be treated as employee salary deferrals, $5,500 would be considered catch-up contributions, and the rest ($33,500) would be attributed to a profit sharing contribution. While the final determination of the actual contribution amount can only be made by the client and his tax advisor, financial advisors who can demonstrate their knowledge of plan contributions for self-employed business owners set themselves apart from the average advisor and, thereby, are better positioned to support their clients.
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The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2013 Columbia Management Investment Advisers, LLC. Used with permission.

Add Your Comments

One Comment

  1. Ross Anderson
    Posted August 28, 2013 at 12:51 pm | Permalink

    the Defined Benefit or combo ps/401k db could be other options worth pursuing depending upon deduction, cash flow and flexibility needs. better to show all the options than just the solo 401k or ps solo 401k option. The irs website has some great reference articles on this subject.

    hope this helps. Ross

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