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.
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.
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.
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)
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.
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.
Shouldn't the retirement deductions from the solo 401k apply before determining net profit?
That's how it works for normal 401ks.
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.
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)
"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.
Can my wife then declare her wages as business expenses and then deduct the full amount from wages?
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.
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)
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:
If you’ve exceeded the limit for elective deferrals in your 401(k) plan, find out how to correct this mistake.
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).
Why is earned income for self-employed people after tax if 401k is pre-tax?
You have to pay the self employment tax on your Schedule C Net Profit. Then you get the 401K deduction off your personal income on the 1040. So it reduces the regular income tax but not the self employment tax.
For a sole proprietor:
Compensation = Net earnings = Net profit minus the deductible portion of self-employment taxes.
See page 5, "Compensation" and page 6, "Net earnings from self-employment" in IRS Pub 560.
According to page 6:
Net earnings from self-employment. For SEP and
qualified plans, net earnings from self-employment are
your gross income from your trade or business (provided
your personal services are a material income-producing
factor) minus allowable business deductions. Allowable
deductions include contributions to SEP and qualified
plans for common-law employees and the deduction allowed for the deductible part of your self-employment tax.
Net earnings from self-employment don’t include items
excluded from gross income (or their related deductions)
other than foreign earned income and foreign housing
cost amounts.
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 an
contributions to the plan made on your behalf when figuring net earnings.
Net earnings include a partner's distributive share of
partnership income or loss (other than separately stated
items, such as capital gains and losses). They don’t include income passed through to shareholders of S corporations. Guaranteed payments to limited partners are net
earnings from self-employment if they are paid for services to or for the partnership. Distributions of other income
or loss to limited partners aren't net earnings from self-employment.
For SIMPLE plans, net earnings from self-employment
are the amount on line 4 of Schedule SE (Form 1040),
Self-Employment Tax, before subtracting any contributions made to the SIMPLE plan for yourself.
Nothing here states that the net income has to be reduced by the Self-employment tax.
You just posted it above....
You take into account the income tax deduction for the deductible part of self-employment tax
You are deducting 50% of the SE tax (the employer's half) on Schedule 1 line 15 which goes to 1040 line 10. You only are deducting half of the tax.
I don't understand how deducing taxes happens before determining income works. That line in the definition is not clear in that determination.
Because one-half of the self-employment tax paid is considered to be the employer's portion of the tax (SE tax covers Social Security and Medicare taxes which are half paid by the employer and half paid by the employee), net profit must be reduced by the employer's portion of SE tax to determine the amount that is considered to be the self-employed individual's compensation.
But where is it explained that self-employment tax is supposed to be deducted from Earned Income before any deductions (like 401k)?
As VolvoGirl indicated, it's in the text that you quoted from IRS Pub 560:
For SEP and qualified plans, net earnings from self-employment are your gross income from your trade or business (provided your personal services are a material income-producing factor) minus allowable business deductions. Allowable deductions include contributions to SEP and qualified plans for common-law employees and the deduction allowed for the deductible part of your self-employment tax.
This derives from section 1402(a)(12) of the tax code which excludes from net earnings one-half of self-employment tax.
"Allowable deductions include contributions to SEP and qualified plans for common-law employees and the deduction allowed for the deductible part of your self-employment tax."
This still does not explain why the deduction from self-employment tax has to be taken before the qualified plans one. Why can't I deduct the full amount of gross income from qualified plans before determining how much it has to go through self-employment tax?
The order of operations isn't clear.
We've explained and provided supporting references several times. Contributions to an individual 401(k) are limited to compensation (tax code section 415(c)(1)(B)). Compensation is defined as net earnings (section 401(c)(2)). Net earnings are net profit minus the employer-equivalent portion of self-employment taxes (section 1402(a)(12)). These references clearly specify the order of operations (dependencies) which results in the 401(k) contribution being limited to the net profit minus the deductible (employer) portion of self-employment taxes.