Excess Solo 401(k) deferral is raising my federal tax owed in TurboTax and lowering my QBI, even though it was distributed back to me in the same year

[jds1855]

In 2023, I accidentally over-contributed $18,500 to my Vanguard Individual 401(k) because, in a moment of stupidity, I forgot to account for my work’s 401(k) plan, which I essentially maxed out.

I contacted Vanguard and got the full amount of the excess contribution returned to me the following month, still in 2023. It had lost about $200 in value, so the total amount returned was almost exactly $18,300. As far as I’m aware, completing all of this in 2023 removes any penalties or tax burdens for this mistake.

I’m doing my taxes in TurboTax, and I’ve input the original $18,500 as an Elective Deferral into my Individual 401(k) plan. I’ve also input the 1099-R that Vanguard provided me from the $18,300 distribution, including code 8 that is listed in box 7 (excess deferrals taxable in 2023). After inputting these two items and changing nothing else, TurboTax is now calculating that I owe an additional $896 in federal tax, and $40 more in state tax.

I’ve discovered that adding these two amounts is decreasing my business income, and thus reducing my Business Income Deduction in TurboTax by roughly $3,600. I think this is because the $18,500 deferral reduces my business income, and the $18,300 distribution adds to my non-business income. I believe this change to the source of the $18,500 income is erasing the tax break that $18,500 should be benefiting from, but I cannot figure out how to fix this, or if I even am supposed to be able to fix it.

I’m at a loss of what to do, so any help would be greatly appreciated!

[ThomasM125]

Self-employed retirement plan contributions like you mention would reduce your qualified business income (QBI) and consequently reduce your QBI deduction. Since you corrected the contribution it is like it never happened, so you can leave the contribution off of your entries in TurboTax. The distribution you made is not taxable so you should not deduct the contribution associated with it. 

I would normally expect the $18,500 contribution you entered to show up on line 16 of schedule 1 (qualified pension plan deductions) as a deduction from your personal income. It may not show there if you are over the allowable contribution limit, however. In any event, it shouldn't be reflected on your tax return, so I am going to suggest you remove it.

You entered the 401-K elective deferral in the Less Common Business Situations section of TurboTax. You need to edit that entry to remove it.

On another screen you will see the 401-k deferral and you can delete the entry:

You can then look at your Form 1040 and see if your pension income and deductions populated properly and get back to us if you still have issues:

To view your form 1040 and schedule 1 to 3:

1. Choose Tax Tools from your left menu bar in TurboTax Online
2. Choose Tools
3. Choose View Tax Summary
4. See the Preview my 1040 option in the left menu bar and click on it
5. Choose the Back option in the left menu bar when you are done 

[jds1855]

Thank you so much for your detailed reply @ThomasM125. I’ve followed your instructions, but removing the Individual 401(k) contribution has increased my taxes owed. This is because the 1099-R is still reporting $18,300 in taxable income from the corrective distribution.

The Vanguard 1099-R lists $18,300 in Boxes 1 (Gross Distribution) and 2a (Taxable amount). Reducing the Taxable amount from $18,300 to $0 fixes the issue, but is obviously no longer accurate.

Do you have a recommendation for how to correct this? Does it seem like Vanguard reported this distribution accurately?

[ThomasM125]

Yes, the box 2(a) taxable amount should be the earnings on the money contributed, if any. It shouldn't have the full amount of the distribution, since you have code 8 in box 7 (return of contribution taxable in 2023). Clearly, the full amount of the distribution is not taxable, as you have until the due date of your tax return to correct an overpayment to your retirement account.

The best thing to do would be to get a corrected Form 1099-R. Otherwise, you may need to make an adjusting entry to Other Income to reverse the pension distribution that is stated incorrectly on the 1099-R form:

You can make that adjusting entry in TurboTax as follows:

1. From the Federal menu in TurboTax find Wages and Income 

2. Find Less Common Income

3. Choose Miscellaneous Income, 1099-A, 1099-C

4. Choose Other Reportable Income

5. Enter a description of the adjustment to income and the adjustment as a negative number

One problem with this approach is you will be reporting pension income on your tax return that can have favorable tax treatment on many state tax returns. If that applies to you, you would need to file your federal tax return before you file your state tax return, so that you can remove the adjusting entry and the pension distribution from your federal return before you finalize your state return.

[jds1855]

Thanks for the guidance, Thomas. I spoke with Vanguard, and I was told that their original reporting of the 1099-R was correct. I was told that, even though it's an Individual 401(k) for my sole-proprietor business, because the original contribution is an employee deferral, that money is taxable income.

It makes sense why they report it that way, but it does end up getting taxed twice when reported as-is: once on the original 1099-NEC where the income originated from, and again on the 1099-R as a corrective distribution.

The only solution that has worked for me is doing an adjustment entry on Other Income as you suggested.

Do you have a suggestion of how to report the negative adjustment in the Other Reportable Income section? I want to make my reporting as clear as possible.

[RobertB4444]

"Corrective return of SE 401K contribution"

Make sure you save all of the documentation on this transaction in case there is a question about it.

@jds1855