Turbo Tax does not allow me to add full self-employment retirement deduction

[gawdiaq23]

Hello, 

My wife has an LLC, and works as self-employed and had a net profit of 11,500 in 2003 plus 2000 in January 2024. I am able to fill in the "Self-Employment Retirement Plans" part of the online tool, but whenever I add the full amount of 13,500 to the solo-401k line the tool says that it has an excessive contribution, even though the limit should be 22,500. It also sets the maximum amount to 10,500, instead of 11,500. Why is that?  I am using Premium version. 

[dmertz · Accepted solution]

First, if your wife's business uses the cash method of accounting, amounts received in 2024 are 2024 business income, not 2023 business income.

Second, the maximum solo 401(k) contribution in this case is net profit minus the deductible portion of self-employment taxes.  For a self-employed individual with net profit of $11,500 and who does not have compensation from another employer that would result in compensation reaching the Social Security wage base, the maximum deferral to the solo 401(k) would be $10,687.

[gawdiaq23]

Why is the maximum 10,687? 
There's nothing in the IRA publication mentioning that number.

Publication 560 (2023), Retirement Plans for Small Business | Internal Revenue Service (irs.gov)

One Participant 401k Plans | Internal Revenue Service (irs.gov)

[VolvoGirl]

First of  yall the 2,000 in Jan 2024 goes on your 2024 return next year.  So for 2023 you have a Net Profit of 11,500.  You have to take off 1/2 of the self employment tax.  If you have self-employment income you can only contribute up to your net profit reduced by the deduction allowed for the ER portion of your self-employment taxes. The 1/2 SE Tax amount will be on Schedule 1 line 15 which goes to 1040 line 10.  The self employment tax is 15.3% SE tax on 92.35% of your Net Profit.

The self employment tax on 11,500 is $1,626.  1/2 of that is $813. 

$11,500 - 813 = 10,687.

[VolvoGirl]

And yes in that link you posted, scroll down to Net Earnings from self employment and it says....

For the deduction limits, earned income is net earnings for personal services actually rendered to the business. You take into account the income tax deduction for the deductible part of self-employment tax and the deduction for contributions to the plan made on your behalf when figuring net earnings.

[gawdiaq23]

Shouldn't the retirement deductions from the solo 401k apply before determining net profit?
That's how it works for normal 401ks.

[VolvoGirl]

Not for self employment.  That is different than W2 income.   The retirement deduction is not on schedule C but is a direct deduction on the 1040.   So you do get the full deduction from your income tax but it doesn't reduce the self employment tax on your net profit.  

[gawdiaq23]

The example the IRA makes in their website for Ben Ben deducts 19,500 before paying taxes. Why does he get to deduct 19,500 but my wife not?

Example: Ben, age 51, earned $50,000 in W-2 wages from his S Corporation in 2020. He deferred $19,500 in regular elective deferrals plus $6,500 in catch-up contributions to the 401(k) plan. His business contributed 25% of his compensation to the plan, $12,500. Total contributions to the plan for 2020 were $38,500. This is the maximum that can be contributed to the plan for Ben for 2019.

One Participant 401k Plans | Internal Revenue Service (irs.gov)

[VolvoGirl]

I'll page someone who know more about that  @dmertz 

[dmertz]

"Ben" in the IRS example is not self-employed, Ben is an employee of an S corp.  You said that your wife is self-employed, implying that her LLC has not made an election to be an S corp.  If your wife has made the election to be an S corp, contributions to the solo 401(k) are handled on the S corp's tax return and any elective deferral would have been reported in box 12 of her W-2 from the S corp.

Assuming that your wife is self-employed (the LLC is not an S corp), see the worksheet in Chapter 5 of IRS Pub 560 for the method used to calculate that the maximum permissible contribution to the solo 401(k) is $10,687 due to being limited to net earnings (section 415(c)(1)(B) of the tax code).  Net earnings are net profit minus the deductible portion of self-employment taxes.

[gawdiaq23]

Can my wife then declare her wages as business expenses and then deduct the full amount from wages?

[dmertz]

What wages?  If she is self-employed, she does not receive wages.  When one is a sole proprietor, the business is a disregarded entity, the net profit is taxable income and net earnings are net profit minus the deductible portion of self-employment taxes.  There is no deduction for net earnings from self-employment because tax must be paid on the income.

[gawdiaq23]

I'm not an accountant to understand all of the differences between wages, income and earnings in this context, but the IRS specifically states that elective deferrals can be made up to 100% of compensation. 

Why can't she elect to defer the full 11,500? Why does it have to get taxed the self employed tax before?

One Participant 401k Plans | Internal Revenue Service (irs.gov)

Contribution limits in a one-participant 401(k) plan

The business owner wears two hats in a 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute both:

• Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
  • $23,000 in 2024 ($22,500 in 2023; $20,500 in 2022; $19,500 in 2020 and 2021), or $30,000 in 2023 ($27,000 in 2022; $26,000 in 2020 and 2021) if age 50 or over; plus
• Employer nonelective contributions up to:
  • 25% of compensation as defined by the plan, or
  • for self-employed individuals, see discussion below

If you’ve exceeded the limit for elective deferrals in your 401(k) plan, find out how to correct this mistake.

[VolvoGirl]

But you don't get compensation.  That is for employees getting a W2.  You are self employed.  You have earned income like it says in the article you posted...("earned income” in the case of a self-employed individual).  And "earned income" is your Net Profit minus 1/2 of the self employment tax (the employer portion).

[gawdiaq23]

Why is earned income for self-employed people after tax if 401k is pre-tax?