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Rules for correcting solo 401k over-contributions
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4 Replies
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Hey there!
I read something about being able to remove accidental over-contributions before April 20 of the following year.
Is that true?
The reason I ask is that I’m an expat and claim the Foreign Earned Income Exclusion (FEIE), and in order to contribute to my solo 401k, I need to have more taxable income than the FEIE. The IRS only allows me to contribute “unexcluded” income.
I still don’t know exactly how much I’ll earn over the FEIE. So if I contribute to my solo 401k throughout the year and realize at the end of 2023 that I earned less than expected, I would have to remove a portion of my contributions.
Is this a reasonable plan if I’d like to DCA into my 401k throughout the year?
Or am I better off just waiting until the beginning of 2024 (when I know my exact 2023 income) to make a larger lump sum contribution?
Thanks so much!
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Good question. The IRS rules allow for solo 401k contributions (pretax, Roth and voluntary after-tax) to be made by the self-employed individual’s self-employed business due date plus business tax return extension. I suspect this is to allow the self-employed to better plan for making contributions.
As a result, It is best not to contribute to the solo 401k plan until you have the required self-employment income to justify the contributions.
However, see the following regarding the excess solo 401k contribution rules: https://www.mysolo401k.net/dealing-excess-nondeductible-solo-401k-individual-k-contributions/
First Determine Contribution Type
When removing excess contributions from a solo 401k plan, you first need to determine the type of contribution being removed. There are 2 (two) types of contributions that apply to a solo 401k plan.
- Type 1 (one): Employee Contributions that exceed the annual limit
- Type 2 (two): Employer/Profit Sharing Contributions
The Rules Are Different for Each Contribution Type
The rules for removing the employee contributions vs the employer profit sharing contributions are different and are discussed below.
Here is what the IRS code says regarding removing Employee Contributions
If the excess salary deferral is not returned on or before April 15 of the following year, the contributing participant must pay income tax on the deferral both in the year of deferral and in the year of distribution. The deferrals are not included as after-tax assets even though they have previously been included in income in the year of deferral (IRC Sec. 402(g)(1) and (Treas. Reg. 1.402(g)-1(e)(8)). The earnings on the excess will be taxed in the year of distribution. Any corrective distribution of less than the entire amount of the excess deferral plus income is treated as a pro rata distribution of excess deferrals and income (IRC Sec. 402(g)(2)(D), Treas. Reg.1.402(g)-1(e)(10)).
For the employer contributions (profit sharing), here is what the rules state:
- They will need to remain in the solo 40k plan and be treated as contributions in future years. However, a 10% penalty will need to be paid on the over contribution amount also known as the excess nondeductible contribution amount pursuant to (IRC Sec. 4972).
- This penalty amount of 10% will need to be reported by the solo 401k owner by filing IRS Form 5330, Return of Excess Taxes Related to Employee Benefit Plans, and remit the penalty to the IRS.
- Please refer to IRC Sec. 404(a)(1)(E) as it details that the amount of the otherwise deductible contribution that exceeds the limitation for any given year shall be carried forward indefinitely and applied to subsequent years.
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Thank you for this clear and helpful explanation. Regarding excess profit sharing contributions, is it me who decides if a contribution was employer vs employee (and record in my own recordkeeping), or is that reported independently to the IRS by my brokerage?
For example, for 2024 I’ve put $20,000 into my solo 401k as employer profit sharing contributions, but now that we’re at year end it turns out I’m only going to eligible to contribute $18,000. So I’ll have over-contributed profit sharing contributions by $2,000.
However, I haven’t yet contributed any of the $23,000 employee contributions I’m allowed to make.
Could I just now contribute only $21,000 of employee contributions, and simply note in my records that the $2,000 in question was actually an employee (not employer) contribution?
Thus making my total contributions be $20,000 previously contributed + $21,000 contributed now = $41,000 contributed, of which $18,000 is my max profit sharing and $23,000 is my max employee contribution.
If allowed, this strategy would mean I haven’t actually made a profit sharing over-contribution at all and owe no penalty. But is it allowed? In the brokerage in which I contribute to my Solo 401K, I must log into different sites to make employee vs. employer/profit sharing contributions, and check a box stating whether it’s an employee or employer/profit-sharing contribution. That said, my understanding is that since the brokerage is not the record-keeper/owner, none of those designations mean anything — it’s the employer’s (my) responsibility to keep records of what contributions were what.
If that’s true (?) then I think I can easily fix this profit-sharing over-contribution by simply under-contributing as the employee?
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Because you have not yet filed your 2024 tax return, yes, you can treat the $2,000 as employee pre tax contribution since it was deposited to the pre tax solo 401k brokerage account and when treated as an employee contribution it does not exceed the $23,000 annual employee contribution limit for 2024.
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