Solo 401k deduction

[hesformes]

I maximized my contribution to my solo 401k, which brought my refund to about $1100. When I filled that same amount in the box asking what amount was attributable to my business, it went to me owing  about $950. I can only contribute to this 401k because I have my business, so why is that when I attribute the contribution to the business (what else can I attribute it to?), that my ability to use it as a deduction disappears? Thank you.

[LindaS5247]

Your refund was likely reduced because based on your Self Employment Income, the amount allowable to be contributed to your Solo IRA was likely limited.

Click here for IRS Guidelines on Solo 401(k) Plans and the calculation of maximum deferral amount.

Per the IRS:

Contribution limits for self-employed individuals

You must make a special computation to figure the maximum amount of elective deferrals and non-elective contributions you can make for yourself. When figuring the contribution, compensation is your “earned income,” which is defined as net earnings from self-employment after deducting both:

• one-half of your self-employment tax, and
• contributions for yourself.

Use the rate table or worksheets in Chapter 5 of IRS Publication 560, Retirement Plans for Small Business, for figuring your allowable contribution rate and tax deduction for your 401(k) plan contributions. See also Calculating Your Own Retirement Plan Contribution.

Note: If all of your income comes from self-employment your taxable compensation is your business net profit.  Schedule 1, Line 3 less self-employment tax deduction which is on Line 15 of Schedule 1. 

TurboTax can calculate your maximum contribution for you.  

Once your self-employment income is entered:

• In your return, type SEPIRA contributions (use the whole phrase) in the Search box.
• Select the Jump to link at the top of the search results.
• This will take you to the Self-Employed Retirement Plans screen.
• Note: If you get a message "Self-Employed Retirement Plans are only for self-employed individuals", this means that you haven't entered your self-employed income.
• TurboTax will ask you whether you contributed to different types of retirement plans. Select Yes to Solo or Roth 401k.
• Check the box to Maximize Contribution to Individual 401k.
• Click Continue.

To make sure you properly entered your Solo 401(k) contributions in TurboTax click here.

[dmertz · Accepted solution]

This question is asked to determine how much a a self-employed health insurance deduction you can take.   The sum of the deductible portion of self-employment taxes, your self-employed retirement deduction and your self-employed health insurance deduction are limited to your net profit from self employment.  Until you tell TurboTax the amount of your self-employed retirement deduction is attributable to the same business as your self-employed health-insurance deduction, TurboTax assumes that your entire self-employed health-insurance deduction is permitted (up to the amount of your net earnings from self-employment.  As soon as you enter the required information, TurboTax corrects the calculation, reducing your self-employed health insurance to the amount that remains after accounting for the other two deductions.

If you have only one self-employment business, the amount of self-employed retirement deduction that is attributable to that business is the entire self-employed retirement deduction.

Because the self-employed retirement deduction only defers taxable income, it's often advisable to limit your self-employed retirement contributions so as to maximize your self-employed health insurance deduction.  Unlike the amount of your self-employed retirement deduction, the amount of your self-employed health insurance deduction is an amount on which you will never pay taxes.

[hesformes]

Thank you for your very informative and complete answer. I am now wondering if I can't make lemonade from this lemon. Is it possible for me to recharacterize the exact amount of my health insurance deduction from my solo 401k to a Roth solo 401k? Though I would still be paying more taxes for this year, this would give the future tax benefit of not having to pay taxes on that recharacterized amount plus any gains it makes. Is this doable.

[dmertz · Accepted solution]

Recharacterizations of 401(k) contributions are not permitted.  Going forward, though, you are correct that allocating some of your maximum elective deferral to be designated Roth contributions will reduce the deduction for the self-employed retirement contributions and will increase the amount that you are eligible to deduct for self-employed health insurance.  Not only that, it can possibly increase the amount that you are eligible to contribute to an IRA since the amount of compensation available to support an IRA contribution is not reduced by designated Roth contributions to the 401(k).

And one additional note:  SECURE 2.0 makes it possible for the employer contribution to the 401(k) now to be made to the designated Roth account as well.  However, plans are not required to offer this option, so an update to your plan agreement would be needed to support this option.

[hesformes]

Thank you again. I'm wondering that since I made this 401k contribution in 2022 and I have not yet filed my taxes, might it be possible to ask my brokerage to transfer the money to a Roth 401k since it is prior to actually filing and it not be considered a recharacterization? I've never recharacterized before, so I know nothing about it.