SOLO 401K Profit Sharing: What You Need to Know

Profit sharing, in the context of your solo 401k, means sharing a portion of your LLC’s profits with yourself as an employer contribution to your retirement account. It’s separate from your employee contribution, which is based on your net self-employment income.

Here’s how it works:

Calculate your net self-employment income: This is your business profit minus all allowable business expenses. You can find this on your Schedule C when filing your tax return.
Determine the employer profit-sharing contribution: You can contribute up to 25% of your net self-employment income, or $66,000 for 2023, whichever is less.
Deduct all expenses and 401k contributions: You can deduct all your business expenses before calculating your net self-employment income, which ultimately determines your employer profit-sharing contribution. Both employee and employer contributions are tax-deductible for your business.

Essentially, you’re reducing your taxable income by contributing to your retirement while also sharing the success of your business with yourself. It’s a win-win for your future and your tax bill.

Here are some additional points:

There’s no requirement to distribute the profit-sharing amount immediately. It can stay invested in your 401k and grow tax-deferred until you retire.
You can choose different profit-sharing formulas: Some businesses use a flat percentage of profits, while others base it on individual performance or specific metrics.
Make sure your solo 401k plan document allows for profit-sharing contributions. You may need to amend your plan if it doesn’t currently include this provision.

Can You Have Both a 401(k) and a SEP IRA?

you can still make employer profit-sharing contributions to your solo 401k even though you don’t have a W-2 and are the only member of your LLC. This is a unique advantage of solo 401ks compared to other retirement accounts like SEP IRAs.

Here’s why:

Solo 401ks allow both employee and employer contributions: As the only member of your LLC, you can wear both hats. You can contribute as an employee based on your net self-employment income, and you can also contribute as an employer based on your business profits.
Employer profit-sharing contributions are based on business profits, not W-2 income: This means you don’t need a W-2 to make these contributions. As long as your LLC shows a profit, you can contribute up to 25% of your net self-employment income (or $66,000 for 2023, whichever is less) as an employer profit-sharing contribution.
There is no requirement to have W-2 employees: Solo 401ks are designed for single-member LLCs and sole proprietors, so there is no rule saying you need to have other employees to make employer contributions.

However, there are a few things to keep in mind:

You must have established your solo 401k by the tax filing deadline for your business (including extensions). If you haven’t done so yet, you can still make employer profit-sharing contributions for 2023, but you won’t be able to make employee contributions.
You can’t contribute more than the total solo 401k contribution limit, which is $66,000 for 2023. This includes both employee and employer contributions.
Make sure you follow all the IRS rules for solo 401ks, such as filing the appropriate forms and adhering to the deadline.

If you’re unsure about anything, it’s always best to consult with a tax advisor or financial professional. They can help you ensure you’re maximizing your solo 401k contributions and complying with all the IRS rules.

Here is an example, suppose your profit is 30k. Let’s calculate your maximum profit sharing contribution:

Remaining income after employee contribution: You’ve contributed $22,500 as an employee, so your remaining income is $30,000 – $22,500 = $7,500.
Maximum profit sharing based on remaining income: You can contribute up to 25% of your remaining income as an employer profit-sharing contribution. So, 25% * $7,500 = $1,875.
Total solo 401k contribution limit: Remember, the total contribution limit for 2023 is $66,000. You’ve already contributed $22,500 as an employee, so you have $66,000 – $22,500 = $43,500 remaining for employer contributions.
Final profit sharing amount: Since your maximum profit sharing based on remaining income ($1,875) is less than the remaining contribution limit ($43,500), you can contribute the full $1,875 to your solo 401k as profit sharing.

Therefore, with a self-employment income of $30,000 after deducting expenses and an employee contribution of $22,500, you can contribute a maximum of $1,875 as profit sharing to your solo 401k in 2023.

Remember, this is just the maximum amount you can contribute. You can choose to contribute a lower amount if you prefer.