One of the things S Corporation owners should think about is setting up a 401(k) plan. These tax-advantaged accounts can be an important and effective tool to set aside the business owner’s income for retirement while also providing a tax deduction for every dollar contributed. For S Corporation owner-employees and non-owner employees, the 401(k) can provide a great deal of financial flexibility by offering both traditional and Roth options and even the ability to borrow against one’s balance through a 401(k) loan.
However, the rules for S Corporations’ contributions to a retirement plan can be very different from those for other types of business owners and employees. The last thing you want is for your contribution to be disqualified and lose its tax-advantaged status. Below, we discuss some of the ins and outs of S Corp 401(k)s and what you should know before setting up your retirement contributions.
Can an S Corporation Have a 401(k) Plan?
Yes! However, there are a few basic rules.
- The Plan can include employee contributions (salary deferrals), and company contributions (non-elective deferrals).
- Both owner employees and non-owner employees can contribute W-2 salary income to a 401(k). This means that owners need to pay themselves a salary and then contribute, instead of directly transferring profits or distributions to a 401(k).
- You can defer up to 100% of your salary up to the maximum 401(k) contribution limit ($22,500 in 2023, or $30,000 if you’re age 50 or older)1.
- The S Corporations can defer an additional 25% of their employees’ salaries, including their owners, as a non-elective salary deferral–essentially a profit-sharing contribution. Unlike elective deferrals, non-elective company contributions must be to a traditional, not a Roth 401(k) plan. These non-elective contributions are subject to some additional limitations that are beyond the scope of this article concerning top heavy plans2.
- Contributions to an S Corporation 401(k) plan must be made within 15 days of the corresponding pay period. In other words, you cannot wait until the end of the year to make a lump-sum contribution; instead, you should make regular contributions throughout the year3.
Each of these rules can provide ways for you to optimize your income and savings rate to lower your tax bill.
S Corp 401(k) Contribution Rules
In addition to the rules outlined above, there’s an important one that can help S Corporation owners avoid problems with the IRS: reasonable compensation.
Many S Corporation owners carefully curate their income to minimize self-employment tax. But under IRS rules, all compensation must be “reasonable.” In other words, you can’t pay yourself an artificially low salary just to avoid self-employment tax; doing this is an easy way to get yourself hit with back taxes, penalties, and fees4.
So what is “reasonable compensation”? There’s no one-size-fits-all definition; what’s reasonable in the IRS’s eyes can depend on your industry, business size, training and experience, time dedicated to the business and the services you provide to the business.
The more data you have, the better, and RCReports can help. We’re bringing transparency to the process by giving you verified information on what others in your industry are earning, helping you ensure that you’re compensating yourself (and others on your payroll) in a reasonable and IRS-recognized manner.
Does 401k Contribution Count as Earned Income?
Any contribution you make to a traditional 401(k), that is your elective deferral, is treated as earned income for Social Security and Medicare purposes, but not for federal or state income tax purposes5. In other words, you won’t pay any federal or state taxes on the amount you contribute to a 401(k) and the savings are pretax.
A Roth 401(k), on the other hand, must be made from after-tax dollars–meaning you don’t get a deduction for those amounts. By paying taxes on Roth 401(k) contributions at the time the contribution is made, you can enjoy tax-free growth and distributions later6. Having a mix of both traditional and Roth 401(k) contributions can give you maximum flexibility when it comes to withdrawing funds from your retirement accounts and continuing to minimize taxes in your golden years.
What are the Tax Implications of an S Corporation 401(k)?
If you have at least $22,500 in income, you can avoid any federal taxes on this amount by making the maximum contribution to your S Corporation 401(k). Many S Corporation owners will add their spouse or even their adult children to the payroll, as long as they are providing services to the company, so they can also defer some or all of this income into a retirement plan.
Of course, there are few jobs where a $22,500 annual salary is sufficient, at least for an S Corporation owner. Similarly, the IRS can grow suspicious if it finds you’ve paid yourself too high a salary. This may be where your additional nonelective deferrals come in. For every extra $100 you pay yourself over $22,500, you can set aside up to $25 in an S Corp 401(k), up to the annual deferral limit. For 2023, the total contribution limit for all S Corporation, elective deferrals and non-elective contributions combined into a 401(k) plan is $66,000—which is a major chunk of change to be able to shield from federal income taxes, so long as your salary is considered reasonable.
What if you can’t afford to pay reasonable compensation? For example, your business may just be getting off the ground, making it tempting to sink every last dollar back into the business. And if you’re not yet turning a profit, it can seem foolish or wasteful to pay yourself a salary at this early point.
Fortunately, there’s a clear answer to this question. Because “reasonable compensation” is tied to distributions, not profit or loss, it doesn’t hinge on your business’s profitability. That is, in booming times, you may be able to take a distribution and reasonable compensation; in leaner times, you may be able to take only reasonable compensation, or nothing at all. But what you can’t do is take a distribution without paying yourself reasonable compensation.
If you don’t want to give yourself reasonable compensation for a particular calendar year, you can refuse all compensation (including distributions), then make catch-up distributions (and contributions) later. But remember, 401(k) contributions are subject to annual limitations and can’t be “caught up” in excess of those limits.
If you’re an accounting professional interested in learning more about reasonable compensation, let RCReports assist you. Our team will collaborate with you to provide the data and insights you require for informed decision-making regarding your clients’ S Corporation’s funds.
References
1. 401(k) limit increases to $22,500 for 2023, IRA limit rises to $6,500 | Internal
Revenue Service. (n.d.). https://www.irs.gov/newsroom/401k-limit-increases-to-22500-for-2023-ira-limit-rises-to-6500
“The contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased to $22,500, up from $20,500.
The limit on annual contributions to an IRA increased to $6,500, up from $6,000. The IRA catch‑up contribution limit for individuals aged 50 and over is not subject to an annual cost‑of‑living adjustment and remains $1,000.
The catch-up contribution limit for employees aged 50 and over who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased to $7,500, up from $6,500. Therefore, participants in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan who are 50 and older can contribute up to $30,000, starting in 2023. The catch-up contribution limit for employees aged 50 and over who participate in SIMPLE plans is increased to $3,500, up from $3,000.”
2. S Corp 401k: Everything You Need to Know. (2020, October 26). UpCounsel.
https://www.upcounsel.com/s-corp-401k
“In addition to a Solo 401(k), S-Corporation owners have several options
for retirement planning, including the following:
Simplified Employee Pensions (SEPs) — pension or retirement plans for
business owners and employees that allow of up to 25 percent salary contributions of all employees’ salaries. Only the business owner contributes, setting up accounts for each employee.SIMPLEIRAs— plans in which business owners contribute either through a matched (employee elected) contribution up to 3 percent or a non-elective contribution of 2 percent for each eligible employee.”
3. Internal Revenue Service. (2022, December 21). 401(k) Plan Fix-It Guide.
“Department of Labor rules require that the employer deposit deferrals to
the trust as soon as the employer can; however, in no event can the deposit be later than the 15th business day of the following month. Remember that the rules about the 15th business day isn’t a safe harbor for depositing deferrals; rather, that these rules set the maximum deadline. DOL provides a 7-business-day safe harbor rule for employee contributions to plans with fewer than 100 participants.”
4. Internal Revenue Service. (2023d, July 27). Paying Yourself.
https://www.irs.gov/businesses/small-businesses-self-employed/paying-yourself
“Because an officer of a corporation is generally an employee with wages subject to withholding, corporate officers may question what is considered reasonable compensation for the efforts they contribute to conducting their trade or business. Wages paid to you as an officer of a corporation should generally be commensurate with your duties.”
5. Intenal Revenue Service. (2023, May 3). Retirement Plan FAQs Regarding
Contributions – Are Retirement Plan Contributions Subject to Withholding
for FICA, Medicare or Federal Income Tax?
6. Internal Revenue Service. (2023a, January 4). Roth Account in Your Retirement
Plan. https://www.irs.gov/retirement-plans/roth-acct-in-your-retirement-plan
