The Mechanics of a Solo 401(k) For an S-Corporation Owner

Q: Could you walk me through how a Solo 401(k) would work for an S-corporation owner?
Randall

A: The first thing to keep in mind is that a Solo 401(k) can only be used at a business with no employees besides the owner and spouse.  If you have other employees, a regular 401(k) or another plan (SEP-IRA, SIMPLE, etc.) must be used.

A S-corporation is a strange beast indeed.  Read more about them here before proceeding.

By now, you know that an S-corporation owner must pay herself a "reasonable salary" (that is, what one could expect to receive on the open market, influenced by the facts and circumstances of the business).  This is where we must begin...

It's from this salary that the Solo 401(k) is calculated.  There are two parts to a 401(k)--the employee's deferral, and the employer contribution.

The employee deferral is straightforward: $15,500 in 2008 (plus $5000 if over age 50).  This comes right out of the paycheck, and must be set up by your payroll administrator.  The deferral can be either pre-tax or "Roth" (yield-exempt).  The S-corporation deducts the deferral as part of "pension, profit sharing, etc. plans" on Form 1120-S, Line 17.  The rest of wages goes on "officer compensation" on Form 1120-S, Line 7.

The employer contribution is limited to 25% of "compensation."  For these purposes, "compensation" is usually defined as gross wages before any payroll deductions.  This, too, is deducted as "pension, profit sharing, etc." on the 1120-S, Line 17.

Together, the employee deferral and the employer contribution cannot exceed $46,000 in 2008 (the $5000 catch-up deferral is on top of this).

Example

Suppose you're an S-corporation owner under 50 and you want to make a maximum Solo 401(k) contribution in 2008.  You would have to pay yourself a "reasonable salary" of $122,000.  Here's why:

1. Salary of $122,000 is paid.
2. $15,500 is deferred from this salary
3. 25% of $122,000 is $30.500
4. $15,500 plus $30,500 is $46,000: the maximum 2008 amount

The $46,000 is accounted for on Line 17.  The $106,500(All other things being equal)