Archives for March 2024

Digging Into Solo 401(k) Contribution Limit Math

Nearly every week I receive emails telling me that my solo 401(k) contribution limit calculator is wrong. Those emails are generally based on one of two misunderstandings.

The first category of email is something to the effect of, “I’m confident that the employer contribution limit is 25% of the business’s profit instead of 20%.”
And the second is something along the lines of “where on earth did you get the idea that the employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution?”

Let’s dig into both of these.

The “25% of Compensation” Limit

The limit in question, which comes from IRC 404(a)(3), says that the employer contribution is limited to 25% of compensation. Note that this is the exact same limit that applies for employer contributions when the worker in question is an employee.

For an employee, “compensation” is a reasonably obvious amount. For a sole proprietor, compensation is defined as:

Profit, minus half of self-employment tax, minus the employer contribution.*

Note that we have circular math going on here. The employer contribution limit is 25% of compensation, and the definition of compensation includes a deduction for the employer contribution.

So we have to do a little algebra. We start with our rule from 404(a)(3):

Employer Contribution ≤ 25% of Compensation

And given our definition of compensation above, we can restate that as:

Employer Contribution ≤ 0.25 x (Profit – SETax/2 – Employer Contribution)

And then we do the following algebra:

Employer Contribution ≤ 0.25 x (Profit – SETax/2 – Employer Contribution)
4x Employer Contribution ≤ Profit – SETax/2 – Employer Contribution
5x Employer Contribution ≤ Profit – SETax/2
Employer Contribution ≤ 0.2 x (Profit – SETax/2)

Or said differently, the employer contribution is limited to 20% of net earnings from self-employment, when we define that as “profit minus half of self-employment tax.”

You can see the IRS doing this math in the “Rate Table for Self-Employed” in IRS Publication 560. It’s the reason that table exists (i.e., to convert from an employer contribution limit that’s defined as a percentage of compensation to a contribution limit that is defined as a percentage of net earnings from self-employment).

The “Half of the Difference…” Limit

The calculator also implements a limit in which the employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution.

This limit comes from IRC 415(c), which in this case says that the whole contribution is limited to 100% of compensation.

But again, we have an issue of circular math, given that we’re trying to figure out the contribution limits, and they’re defined based on “compensation” which itself includes a deduction for the employer contribution.

So, again, time for some algebra. We start with the limit as stated in IRC 415(c):

Employer Contribution + Employee Contribution ≤ Compensation

And given our definition of compensation above, we can restate that as:

Employer Contribution + Employee Contribution ≤ Profit – SETax/2 – Employer Contribution

And then we do the following algebra:

Employer Contribution + Employee Contribution ≤ Profit – SETax/2 – Employer Contribution
2x Employer Contribution + Employee Contribution ≤ Profit – SETax/2
2x Employer Contribution + Employee Contribution ≤ Net Earnings From Self Employment (when we again define that as profit minus half of self-employment tax)
2x Employer Contribution ≤ NEFSE – Employee Contribution
Employer Contribution ≤ (NEFSE – Employee Contribution) / 2

Or as stated on the calculator’s page, “the employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution.”

You can see the IRS doing this math in step 11 and step 12 of the “Deduction Worksheet for Self-Employed” in Publication 560.

*This definition of compensation comes from IRC 415(c)(3)(B) and 404(a)(8), which both define compensation for self-employed individuals as the earned income of the individual as defined in 401(c)(2). 401(c)(2) uses the definition of net earnings from self-employment from 1402(a) but makes various modifications to that definition (including that we have to back out the employer contribution and the deduction for 1/2 of self-employment tax).

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

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Topics Covered in the Book:

Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
Self-employment tax: What it is, why it exists, and how to calculate it,
Business retirement plans: What the different types are, and which one is best for you,
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March 25, 2024

Investing Blog Roundup: Financial “Pig Butchering” Scams

In my prior roundup article, I referenced a few different types of scams that you’re likely to encounter. In reply, multiple readers recommended the following recent episode of Last Week Tonight with John Oliver. It’s an excellent explanation of another common and clever type of scam that you and your loved ones should be aware of.

Pig Butchering Scams: Last Week Tonight with John Oliver

Can You Give Investment Advice (Without Being a Registered Investment Adviser)?

One question that I am often asked is under what circumstances a person can give investment advice, without needing to be a registered investment adviser (RIA). I want to be clear that what follows is only a high level summary of that topic. If this is more than just a curiosity for you, I would encourage you to consult with an attorney with relevant expertise.

Where to Find the Rules

The actual relevant legislation consists primarily of:

The Investment Advisers Act of 1940, and
Some statute in your state which is probably very closely based on (but not absolutely 100% identical to) the Uniform Securities Act.

And then there are of course various other relevant sources such as regulations, court cases, etc.

What’s an Investment Adviser (“ABCs Test”)

The Investment Advisers Act of 1940 defines an investment adviser as: “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

The Uniform Securities Act includes a definition that is nearly identical to the above.

People often use the mnemonic device “ABCs” to remember this test. That is, an investment adviser is somebody who is 1) in the business of 2) giving advice 3) about securities 4) for compensation. (Advice, Business, Compensation, Securities.)

And the idea is that you have to meet all of those requirements before you’d need to register as an investment adviser.

So, for example, if you’re a nurse and your daughter comes to you asking how she should invest in the 401(k) at her new job, you are perfectly allowed to give her advice. And there’s no need for a “this is not investment advice” disclaimer. It is advice about securities, but you’re not receiving any compensation, nor does your daughter have any reason to think that you’re “in the business” of providing investment advice for compensation. You don’t meet the ABCs test and thus don’t have to register as an investment adviser.

One important point here is that the SEC and state regulators tend to interpret the above tests as broadly as possible (i.e., to include as many people under the definition as possible). So, for example, any economic benefit received in exchange for the advice would be probably considered “compensation.”

Exclusions

The 1940 Act and Uniform Securities Act also provide exclusions. That is, there are certain people who do meet the above requirements (i.e., they satisfy the ABCs test) but who are nonetheless explicitly excluded from the definition of investment adviser — and thus don’t have to register as investment advisers.

Some of those exclusions include:

Any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his/her profession.
Any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation for the investment advice.
The publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation.
A bank or savings institution.
Any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States.

This is why, for example, somebody can write a blog that discusses all sorts of investment topics, without having to register as an investment adviser. It’s also why somebody can teach a personal finance class — and provide investment advice in that class — without having to register as an investment adviser.

I will note that, as somebody who is a practicing CPA, the exception for accountants is somewhat challenging to apply in real life.

Firstly, what specifically is meant by “the practice of my profession”? That is, what services are considered included in my profession as an accountant, so that we can then try to figure out what would be “incidental” to that profession? At least here in Missouri, public accounting is defined as “services involving the use of accounting or auditing skills, or one or more management advisory or consulting services, or the preparation of tax returns or the furnishing of advice on tax matters.” So basically, accounting includes tax preparation, tax advice, management advisory or consulting services, and “services involving the use of accounting skills” — a pretty circular definition.

And what would be “solely incidental” to that practice? That wording is clearly intended to be vague (i.e., determined on a case-by-case basis, depending on the facts and circumstances). So it’s no surprise that different accountants will draw the line in different places, as far as what degree of investment-related advice they feel comfortable giving.

So, in short, if you meet the “ABCs test” (i.e., you’re in the business of giving advice about securities, in exchange for compensation) when that test is interpreted as broadly as possible (i.e., to include as many people as possible), and you do not fall under one of the explicit exclusions, you probably need to register as an investment adviser. But again, if you’re even remotely unsure about whether something you’re doing (or considering doing) would require you to register as an investment adviser, I’d encourage you to consult with an attorney.

March 11, 2024

Investing Blog Roundup: Be Careful Out There

Hopefully by now, everybody is familiar with basic online safety measures (e.g., even if you have a Bank of America account, don’t click the link in the email from Bank of America — instead directly visit the website and navigate to what you need).

But the tools and techniques used by scammers keep improving, as we can see in the articles below:

Calendar Meeting Links Used to Spread Mac Malware from Brian Krebs
Finance Worker Pays Out $25 Million After Video Call with Deepfaked CFO from Heather Chen and Kathleen Magramo
A Real-Life Pump and Dump Scam Experience from Jim Dahle