SOLO 401K for Independent Contractor 25% of what?

[HS8]

I want to contribute the max to a SOLO 401K as an independent contractor. TY 2022.  I put in:

$3500 as employee elective deferral

$6500 as employee elective deferral catch up contribution (over50)

for a total of $10K AND

I put in $31K as employer nonelective contribution

So the total is $41K of retirement investments. TurboTax does NOT flag this as a problem! But I know there is some 25% of "compensation" rule for the employers limit on contributions. But it is passing the error check! I like the results but is it legal?

So what "compensation" do I multiply the 25% limit times, to get the max limit??? My total 1099 NEC was 86250. TTax says my business income is $78451. Is it one of these? And does the resulting limit apply only to the employer nonelective contribution (the $31K) or does the limit apply to all contributions (the $41K)

Finally, can I safely do a "self employment adjustment " on the form in TurboTax to increase my "self employment compensation" so that I can contribute what I plan?

Please help! 

[dmertz · Accepted solution]

If you want to maximize your solo 401(k) contributions you must make the maximum regular elective deferral for 2022 of $20,500 and the maximum catch-up of $6,500.  Your maximum employer contribution is 20% (not 25%; 25% is the base rate that must be adjusted because your employer contribution reduces the amount to which the 25% factor would otherwise be applied) of net earnings.  Net earnings are net profit minus the deductible portion of self-employment taxes.

To have TurboTax calculate the maximum permissible contribution, simply mark the Maximize box and leave the dollar-amount boxes blank.

TurboTax will not flag excess employer contributions.  It will simply limit your deduction to the permissible amount.  If you contribute more than the permissible amount you will have a 10% excess contribution penalty on Form 5330.  TurboTax does not support Form 5330.

With $78,451 of net profit, maximizing your solo 401(k) contributions will mean making a maximum regular elective deferral of $20,500, a maximum catch-up contribution of $6,500 and a maximum employer contribution of $14,582 for a total of $41,582.

[HS8]

Thank you so much! I will try this, BUT I mis-spoke. I actually want to MINIMIZE my taxes, not maximize my retirement deductions. (I got the total of $41K to shoot for initially from Turbotax "maximize." But now, when I click maximize, it gives me a different number. Sigh.)

I would still like to know the answer to the "25% times what "question I asked, and here is what an IRS publication said, it said 25%...

• Overall limit on contributions
• Total annual contributions (annual additions) to all of your accounts in plans are limited. The limit applies to the total of:
• elective deferrals (but not catch-up contributions)
• employer matching contributions
• employer nonelective contributions (no matching by employee)
• The annual additions paid to a participant’s account cannot exceed the lesser of: 100% of the participant's compensation, or  $61,000 ($67,500 including catch-up contributions) for 2022
• However, an employer’s deduction for contributions to a defined contribution plan (profit-sharing plan or money purchase pension plan) cannot be more than 25% of the compensation paid (or accrued) during the year to eligible employees participating in the plan (see Employer Deduction in Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).

You are kind, I implore your additional help?

[dmertz]

You generally minimize your taxes by maximizing your deductions, so I don't see the difference unless you have a large amount of other deductions such that your taxable income is reduced to zero before you reach the maximum solo 401(k) contribution.

"I would still like to know the answer to the "25% times what ""

I answered that.  It's 20%, not 25%, times net earnings.  Net earnings are net profit minus the deductible portion of self-employment taxes.  The 25% factor applies to W-2 employees, not the self-employed who must use an adjusted factor.

If you are now getting a different number for your maximum contribution, perhaps you subsequently entered business deductions that have reduced your net profit.  Check your net profit on Schedule C and the calculations on the Keogh, SEP and SIMPLE Contribution Worksheet.  (I assume that you do not have any W-2 income that could result in reaching the limit on Social Security wages which could mean a slightly higher employer contribution due to a lower deductible amount of self-employment taxes.)

[HS8]

Thanks again @dmertz! I maxed out the SOLO 401k personal, individual contribution as you advised, yay!

Now TTax says I can add solo 401k employer contributions as well; and you have said 

"Your maximum employer contribution is 20% (not 25%) of net earnings. Net earnings are net profit minus the deductible portion of self-employment taxes."

So in my case the business income of $78451 (Schedule 1 line 3 Business income or loss) minus deductible self employment tax (from Schedule 1 line 15?) times 20% for employer contribution.

Then this should be correct?

Whew!  You are the greatest, happy tax season to you (grin)!

[gsu13]

This entire thread was so helpful as I tried to confirm that Turbotax did the "maximize" correctly between employee and employer contribution.  For anyone curious (and also for my own notes if I need to recreate this), to get the Employer contribution amount, look after the Schedule C; there might be the QBI Deduction Smart Worksheet and look for line 3 - Sch C profit (loss), then subtract 5b Total Deduction for 1/2 SE tax.  Then multiply that amount by 20% per @dmertz and you'll arrive at the employer contribution.  That plus your max employee contribution for that year (see IRS docs) plus any catch-up if you're over 50 yo, and that should equal what Turbotax calculates as "maximize."  It seems like to get the super max contributions for 2023 of $76500 = $7500 catchup over 50yo + $22,500 employee contribution, therefore employer match would have to be $46,500 which means your business profit would need to be at least $232,500