It’s time to start thinking about year-end tax planning and as every savvy business owner knows, effective 2015 tax planning happens before December 31, 2015. One of the most commonly used strategies for our clients is an s-corporation and a 401(k). A properly structured s-corporation is utilized best for tax purposes when the business owner adopts and contributes to a 401(k) plan as the contributions to 401(k) are tax deductible. Whether the business has only one owner/employee (or spouses only) or whether the business has dozens or even hundreds of employees, a 401(k) is a great tool to help defer taxable income. Simply put, a 401(k) plan can be used as a tool for putting the income of the business owner (and applicable employees) away for retirement with the added benefit of a tax deduction for every dollar that can be contributed. There are numerous benefits and options in a 401(k) plan. For example, you can do Roth 401(k) account, you can self direct a 401(k) account, and you can even loan money to yourself from your 401(k) account. While books have been written about all of these options and benefits, one of the most misunderstood concepts of 401(k) plans is how s-corporation owners can contribute their income to the plan. That is the focus of this article.
Rules for 401(k) Contribution
In order to understand how s-corporations income can be contributed to a 401(k) plan, you need to understand the following three basic rules.
- Only W-2 Salary Income can be Contributed to a 401(k). You cannot make 401(k) contributions from dividend or net profit income that goes on your K-1. See IRS.gov for more details. Since many s-corporation owners seek to minimize their W-2 salary for self-employment tax purposes, you must carefully plan your W-2 and annual salary taking into account your annual planned 401(k) contributions. In other words, if you cut the salary too low you won’t be able to contribute the maximum amounts. On the other hand, even with a low W-2 Salary from the s-corporation you’ll still be able to make excellent annual contributions to the 401(k) (up to $18,000 if you have at least that much in annual W-2 salary).
- Easy Elective Salary Deferral Limit of $18,000 or 100% of Your W-2, whichever is less. If you have at least $18,000 of salary income from the s-corporation, you can contribute $18,000 to your 401(k) account. Every employee under the plan is allowed to make this same contribution amount. As a result, many spouses are added to the s-corporation’s payroll (where permissible) to make an additional $18,000 contribution for the spouse’s account. If you are 50 or older, you can make an additional $6,000 annual contribution. Follow this link for the details from the IRS on the elective salary deferral limits. The elective salary deferral can be traditional dollars or Roth dollars.
- Non-Elective Deferral of 25% of Income Up to a $53,000 total Annual 401(k) Contribution. This is usually maximized best in solo 401(k) plans where you as the business owner decided to offer them most generous company match allowed by law (25% of wages). Rarely is this offered or maximized like this in a group 401(k) scenario where you have other employees because what you offer yourself, you must offer to all employees who qualify for the plan (full-time, worked for you a year, over 21). If you are in the solo 401(k) situation, this additional 25% deferral is an excellent tool because in addition to the $18,000 annual elective salary contribution, an s-corporation owner can contribute 25% of their salary compensation to their 401(k) account up to a maximum of a $53,000 total annual contribution. This non-elective deferral is always made with traditional dollars and cannot be Roth dollars. So, for example, if you have an annual W-2 of $100,000, you’ll be able to contribute a maximum of $25,000 as a non-elective salary deferral to your 401(k) account. If you have employees who participate in the plan besides you (the business owner) and your spouse, then the non-elective deferral calculation gets much more complicated because you’d have to offer it to those employees too. But for now, let’s assume there are no other employees and run through the examples.
Let’s run through two examples. The first is an s-corporation business owner looking to contribute around $30,000 per year. The second is a business owner looking to contribute the maximum of $53,000 a year.
Example 1: Seeking a $30,000 Annual Contribution.
- S-Corporation Owner W-2 Salary = $50,000
- Elective Salary Deferral = $18,000
- 25% of Salary Non-Elective Deferral = $12,500 (25% of $50,000)
- Total Possible 401(k) Contribution = $30,500
Example 2: Seeking Maximum $52,000 Annual Contribution
- S-Corporation Owner W-2 Salary = $140,000
- Elective Salary Deferral = $18,000
- 25% of Salary Non-Elective Deferral = $35,000 (25% of $140,000)
- Total Possible 401(k) Contribution (maximum) = $53,000
As a result of the calculations above, in order to contribute the maximum of $53,000, you need a W-2 salary from the s-corporation of $140,000. Keep in mind that if you have other employees in your business (other than owner and spouse) that you are required to do comparable matching on the 25% non-elective deferral and as a result such maximization is often difficult to accomplish in 401(k)s with employees other than the owner and their spouse. Consequently, the additional 25% non-elective salary deferral is best used in owner only 401(k) plans. If you do have employees though you can at least do $18,000 per year without having a matching requirement for your employees. That’s still three times what you can contribute to a traditional or a roth IRA. There are also common matching formulas used where you end up matching yourself and your employees contributions at a rate of 4% of salary (safe harbor).
Keep in mind that while 401(k) contributions can be made until the tax return deadline (personal, 4/15/16 and s-corp 3/15/16), including extensions, that the 401(k) must be established before the end of 2015 in order to later make 2015 contributions. As a result, you just need to establish the 401(k) before the end of 2015 and that will allow you to later make 2015 contributions prior to filing your 2015 returns.