Accountants and CPAs often recommend that business owners use an S-Corp as the legal structure for their businesses to reduce income taxes. However, there is far less guidance about how to run a 401k plan when you are an S Corp, which will be the topic of this piece.
Whoa – back up! What’s an S Corp?
An S Corp is a legal structure that allows its profits to pass directly through to the shareholders, and be reported on their tax returns. There are certain requirements you’ll have to meet in order for your business to be deemed eligible (no more than 100 shareholders, single class of stock, etc.)
If you are the owner of an S Corp, you pay FICA tax (Social Security and Medicare) on the salary you take. However, you do not pay these taxes on profits you take.
- Your salary goes through payroll (W-2 income)
- Your profit distributions do not go through payroll
In other words, by structuring your business as an S Corp you avoid paying FICA taxes on anything you take home that does not get processed through payroll.
Operating a 401(k) plan as an S Corp
Whether you converted your business to an S Corp, or you started out that way, having your business structured this way impacts how your retirement plan contributions work. For many businesses, the SEP IRA is the retirement plan used – but it may be limiting you in the amount of contribution you can make in any given year. As your business grows, this may be preventing you from stashing away the most money possible on a tax-deferred basis.
When you are able to make a higher contribution than the SEP limit allows ($66,000 or 25% of employee’s compensation for 2023), a defined benefit or Solo 401(k) plan may make sense for your S Corp. As the 401k is usually the more popular option, let’s start there. Here is how it works in an S Corp structure.
As an owner, your 401(k) contribution has two pieces:
- What you contribute as an employee
- What you contribute as an employer
Remember from above that the employee contribution goes through payroll. The contribution you make as an employer does not go through payroll; there is more flexibility on the timing and amount.
- Your employee contribution will reduce your salary, as you are essentially directing part of your salary to be a retirement plan contribution. Keep in mind that if you let your salary dip too low, it may trigger an IRS audit as regulators are wary of businesses evading taxes.
- You can contribute the lesser of $22,500 or 100% of your W2 income in 2023. If you are 50 or over, you can contribute an additional $7,500.
- Make sure that you do not wait until the last minute to contribute to your retirement plan in an S Corp. In that case, the payroll company has to run a special contribution, and that incurs FICA tax – when the whole point of this structure was to avoid it.
Here’s an example.
Let’s say a business owner, age 40, pays into her 401(k) quarterly.
- The owner’s W-2 salary is $100,000.
- The owner makes a salary deferral (from payroll) of $22,500. If over 50, you can do catch up of $7,500.
- The owner contributes $20,000 from profits as a non-elective deferral.
- The total contribution is less than $66,000, so limits have not been exceeded.
This is only a hypothetical example but it illustrates how a 401(k) contribution may potentially be set up in an S Corp structure.
As you can see, this can get pretty complicated – so if you’re thinking about doing this, let’s talk.
Nothing presented here may be interpreted as financial advice; for suggestions specific to your personal situation, contact a financial advisor. All illustrations are hypothetical in nature and may not be interpreted as financial advice specific to any one person.
Legalzoom. What is an S Corp and is it right for me? https://www.legalzoom.com/articles/what-is-an-s-corp-and-is-it-right-for-me
Sorensen, Mat. (2014, February 18th). Mat Sorensen. 401(k) Contributions from S-Corp Income. https://matsorensen.com/self-directed-ira-investing/401k-contributions-from-s-corporation-income/
IRS. Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits