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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).

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Topics Covered in the Book:
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