IRC Sec. 404 allows employer (including self employed) to take a tax deduction for contributions made to a Self-Directed Solo 401k plan that do not exceed 25 percent of compensation (IRC Sec. 404(a)(3). This deduction is in addition to the salary deferral contribution deduction amount which is $16,500 for tax year 2011 and $17,000 for tax year 2012.
However, before taking the employer tax deduction (the 25% amount), first apply the IRC Sec. 401(a)(17) compensation cap which equals $245,000 for 2011 and $250,000 for 2012. In other words, the compensation cap–the maximum amount of compensation that can be used to calculate your Solo 401k contribution amount–cannot exceed the aforementioned ceiling amounts.
IRC Sec. 404(a)(6) permits the employer tax deduction (the 25% portion) even if the contribution for the immediate prior tax year is made in the following tax year as long as it’s made before an employer’s tax return due date plus (plus extensions).
A common false assumption about profit sharing deduction (the 25% contribution portion) limit (keep in mind that Solo 401k is made up of two types of contributions–profit sharing and salary deferral contributions) is that the 25 percent deduction limit applies on a per participant basis. However, the deduction limit applies on the basis of the aggregate eligible compensation earned by all Solo 401k plan participants (Solo 401k only allows for maximum of two participants–number of people who can contribute/participate to the plan) during the employer’s (self employed) tax year.
When calculating profit sharing contribution amount for deduction purposes,effective January 1, 2002 and after, compensation used to determine the employer’s (self employed) maximum deductible contribution to a plan (including a Solo 401k plan) includes salary deferrals (the $16,500 for 2011 or $17,000 for $2012 contribution portion)
EXAMPLE:John and his wife sally are the only owners and employees of The Computer Company, a corporation, in aggregate they had $200,000 in income for 2011 of which they both contributed a combined total of $33,000 ($16,500 each) as salary deferral contribution to their solo 401k. When calculating their maximum employer contribution, they are not required to reduce the maximum deductible profit sharing deductible contribution by the salary deferral amount of $33,000.
In order to deduct contributions for a given tax year, the business owner is required to make contribution to Solo 401k by employer’s tax return due date, including extensions as outlined in IRC Sec. 404(a)((6).
When calculating the 25 percent (employer contribution portion) Solo 401k contribution limit, the total employer (25%) contribution amount must be divided by the total compensation paid during the self employer tax year to all employees (note that Solo 401k only allows for maximum of two participants, usually husband and wife or two business partners) eligible to participate in the Solo 401k plan.
The compensation definition used for determining a self employer maximum deductible contribution includes salary deferrals [the $16,500 for 2011 or $17,000 for 2012].