A Window of Opportunity
Sole Proprietors have a narrow window of opportunity to adopt a new Solo 401k Plan for their business and make retroactive 401k contributions for 2022--up until their tax filing due date (April 18, 2023 for most sole proprietors). A business owner can make a $20,500 401k contribution for 2022 (or $27,000 if over age 50). What a great opportunity for a tax-deduction and to save for retirement.
This new opportunity is made possible by the SECURE 2.0 Act that just became law on December 29, 2022.
Retroactive Plan Adoption
For several years employers have been able to retroactively adopt a new retirement plan for the prior year since the SECURE Act of 2019 added this provision. But this retroactive ability has never applied to 401k deferrals since those deferrals must be "elected" as a payroll deduction prior to receiving the pay. On the other hand, sole proprietors never know what their "pay" is until they do their tax return after the end of the year, so sole proprietors are generally required to make an election prior to the end of the year, but they can make their actual contributions later, just prior to filing their tax return.
Now SECURE 2.0 of 2022 has added a provision for sole proprietors to retroactively make their 401k deferral election in addition to adopting the Solo 401k plan retroactively.
Are you Eligible?
Do you have earned income from 2022 and want to capture this big deduction for your tax return? You may be eligible if you can answer TRUE to each of these requirements:
- You are an unincorporated sole proprietor. (This includes an LLC taxed as a sole proprietor.)
- You were the ONLY employee in 2022.
- You did NOT have a 401k plan for your business in 2021 or 2022.
- You do NOT participate in another 401k plan (contributing to another 401k limits the amount you could contribute to your own Solo-401k).
- There is still time prior to the un-extended due date for your Form 1040.
How this Works for 2022
The law reads:
SEC. 317. RETROACTIVE FIRST YEAR ELECTIVE DEFERRALS FOR SOLE PROPRIETORS.
EFFECTIVE DATE.—this section shall apply to plan years beginning after the date of the enactment of this Act.
That means it's effective after December 29, 2022. Many people think it only applies to 2023 Plan Years beginning January 1, 2023, which would mean no one can take advantage of this provision until early 2024. But congress made it effective as soon as possible, and there is in fact a way to carefully thread the needle to take advantage of this provision for 2022. Here's how:
- The new Solo 401k Plan must be set up with a SHORT 2-DAY initial Plan Year from 12/30/22-12/31/22. This begins after 12/29/22 and so a retroactive election can be made for this year.
- The Limitation Year must be set as the calendar year ending within the Plan Year, which is the entire 2022 calendar year.
- The Compensation Computation Period must also be set as the calendar year ending within the Plan Year, so it includes all of 2022.
On this basis, the deferral election of $20,500 (or $27,000) is for the entire limitation year and is based earnings from the entire year, so the limit is unreduced even though the Plan Year is only 2 days long.
- Your deferral is also limited to your earned income if that amount is less than the $20,500/$27,000 limit. (There is also an adjustment for 1/2 of Self-Employment Tax.)
- In addition to deferrals, you can also make a Profit Sharing contribution of up to 20% of net earnings. The actual limit calculations can be complex.
- If you are also a part of another 401k (could be your "day job" or a former job), the $20,500/$27,000 limit for the year applies to your total personal deferrals for the year across all plans that you may have been a part of during the year.
- The provision for retroactive deferrals is NOT available for Partnerships, even though they may be taxed similarly to sole proprietors. Sorry. Blame Congress.
- Your deferral could be made as a Roth contribution, which is taxed now but avoids all future taxes on future investment gains.
- If you have questions regarding the specifics of your tax situation you should seek the counsel of a Tax or ERISA attorney.
Contact us as soon as possible if you want to set up a plan now.