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Solo 401(k) Contributions: Employee or Employer?

A reader writes in, asking:

“I have a solo 401k at Vanguard. There’s no way I will hit the total contribution limit for the year, so should I be making employer or employee contributions to the account?”

As background information, if you are a business owner with a solo 401(k) — sometimes referred to as an individual 401(k) or self-employed 401(k) — you can make two types of contributions to the account:

  • An “employee” contribution, limited to $18,000 ($24,000 if age 50 or over) for 2016, and
  • An “employer” contribution, limited to 25% of your net earnings from self-employment (if you are a sole proprietor or LLC taxed as a sole proprietorship) or 25% of your compensation (if you are an owner-employee of an S-corp or LLC taxed as an S-corp).

Solo 401(k) for Sole Proprietors

For a sole proprietor, pre-tax (i.e., “traditional”) contributions (whether they’re employee or employer contributions) will be deducted on line 28 of Form 1040 under “Self-employed SEP, SIMPLE, and qualified plans.”

Because pre-tax employer and employee contributions are deducted in the same way, neither one is more tax-efficient than the other.

That said, because employee contributions can be Roth or pre-tax, whereas employer contributions can only be pre-tax, if you want to make pre-tax contributions, it often makes sense to make them as employer contributions (to the extent possible), thereby saving your (more flexible) employee contribution space, in case you decide that your further contributions should be Roth rather than pre-tax.

Solo 401(k) for S-Corporation Owner/Employees

If your business is taxed as an S-corporation, contributions that you make as an employee would reduce the amount of wages that would appear in box 1 on your W-2 — and therefore the amount of wages that show up on your Form 1040. Note that they do not reduce the amounts that show up in boxes 3 and 5 (“Social Security Wages” and “Medicare Wages”). In other words, these contributions reduce your income tax, but they do not reduce your payroll taxes.

Employer contributions to the solo 401(k) would show up on line 17 of Form 1120S as “Pension, profit-sharing, etc., plans.” This would reduce the amount of income from the S-corporation that would be passed through to you as the owner, thereby reducing your income tax. But, because this income is not subject to payroll taxes in the first place, these contributions will not reduce your payroll taxes.

In other words, for an S-corp owner-employee, employer and employee pre-tax solo 401(k) contributions are equally advantageous (just as they are for a sole proprietor). Though again, by prioritizing employer contributions, you preserve your more flexible employee contribution space, in case you decide you want to make Roth contributions later in the year.

For More Information, See My Related Book:

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

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,
  • Click here to see the full list.
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