Understanding the contribution limits and tax issues that affect your retirement plans can help you avoid costly mistakes and take advantage of available benefits. In most cases, individuals should consult with a competent tax professional to determine the benefits that may apply to their particular situations. Here, we address common questions asked by business owners and those operating employer-sponsored retirement plans as well as questions that pertain to the individual taxpayer. Remember, however, to consult a tax professional should you need more specialized assistance.
Employee With a Business
I work for a corporation that provides a 401(k) plan in which I participate. But I also provide consulting services on the side. Can I establish a retirement plan for my consulting business, and if so, how are contributions to the plan affected by my participation in my employer's retirement plan?
You can establish a retirement plan for your business if your only affiliation with your employer is that you work for the company and have no ownership in the company. Contribution rules will vary depending on the type of retirement account you choose for your consulting business. Each type of retirement account has its own contribution limits.
The individual contribution limit to a 401(k) plan in 2020 is $19,500 with a $6,500 allowance for catch-up contributions. 401(k) plans are also subject to a maximum employee/employer contribution limit. In 2020 this limit is the lesser of 100% of compensation (subject to a $285,000 max) or $57,000.
If you were to contribute to your employer’s 401(k) and set up your own solo 401(k), you would be limited to a combined $19,500 in salary-deferred contributions plus any allowable catch-up contributions in the two different 401(k)s. This limit applies to all 401(k) plans to which you contribute. You can, however, achieve the employer max contribution on both the 401(k) and solo 401(k) separately because that limit only applies to a single employer plan.
Any salary-deferral contributions apply on an individual (per person) basis, rather than on a per-plan basis. This means that regardless of the number of 401(k) plans in which you participate, you cannot make salary deferred contributions of more than $19,500 in 2020. If you are at least age 50 by the end of the year 2020, you may make catch-up contributions of $6,500 for a total of $26,000.
For instance, if you are 35 years old and you plan to defer $5,000 from your salary to the 401(k) plan sponsored by your employer in 2020. You may defer no more than $14,500 ($19,500 minus $5,000) to any other 401(k), including your consulting business solo 401(k) or a Roth 401(k).
The rules for what is referred to as the annual addition amount or defined contribution amount are different, as they apply on a per-employer basis. The annual addition rule limits a participant's contributions under a defined-contribution plan to the lesser of 100% of the participant's compensation or $57,000 in 2020. The $57,000 limit applies to the tax year 2020, but the limit is indexed for inflation, usually in increments of $1,000 each year. The IRS sends a notice in the last quarter of every year indicating whether the limit will increase for the next year. The employee/employer combined limit is inclusive of salary-deferral contributions and employer contributions such as profit sharing and matching contributions. Since the annual-addition limit applies on a per-employer basis and your consulting business is a separate employer from the corporation with which you are regularly employed, you could potentially contribute up to $57,000 in 2020 if the plan is a 401(k). You will need to review the rules for solo 401(k) contributions as they include some restrictions.
Keep in mind that your deferral contribution limits and annual defined contribution limits will depend on the retirement account being used.
Say you earn $250,000 from your employer and that your employer's 401(k) plan includes a profit-sharing feature, which is a type of defined contribution. You can potentially receive up to $57,000 for 2020 to the 401(k)/profit-sharing plan, which is composed of your salary-deferral contributions and employer contributions, such as profit-sharing and matching contributions.
Additionally, because the rules for the defined contribution amounts apply separately to each employer plan, the contributions to the retirement plan you adopt for your business can also be the lesser of 100% of compensation or $57,000, if a 401(k), making your aggregate defined contribution limit higher than it would be under only one plan. Catch-up contributions are also added, if allowed, making the defined contribution limit that much higher.
If you are funding a solo 401(k) through your consulting business, you should consult a financial advisor to be sure you are within the rules. Solo 401(k) plans and other small business retirement accounts funded by a sole proprietor will have some limitations of their own.
Rules regarding contribution limits for multiple plans for multiple businesses are different if the businesses have common ownership or affiliation. In such cases, individuals must consult with a competent tax professional or plan administrator to determine the applicable rules.
Making Salary-Deferral Contributions to Two Plans
If I participate in two employer-sponsored plans, can I make salary-deferral contributions to both?
Yes. Any salary-deferral contributions will comprehensively be subject to the IRS’s annual limits. These limits will vary by account type. Any individual can potentially max out the salary deferral contribution limit on each type of plan they are participating in. Salary deferral limits apply by plan type, so regardless of whether you are participating in a traditional 401(k), Roth 401(k), or solo 401(k), you can only make salary deferred contributions of $19,500 in 2020 to all 401(k) plans combined plus any eligible catch-up contributions.
Moreover, the salary deferred contribution limit also applies comprehensively to other retirement account types. Thus, you can only make $6,000 of salary deferred IRA contributions to all of your IRAs in 2020 plus the $1,000 catch-up contribution if eligible.
Some of the common salary deferred contribution limits for 2020 to be aware of include:
- 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan: salary deferred contribution limit of $19,500 plus $6,500 catch-up
- IRA: salary deferral contribution limit of $6,000 plus $1,000 catch-up
- SIMPLE: maximum defined contribution limit 13,500
- SIMPLE: salary deferral catch-up contribution limit 3,000
- SEP: only allows employer contributions
In some instances, the limit across several plans may have varying restrictions. This can be the case if you participate across a 403(b), 401(k), and a government 457(b) plan. When contributing across multiple alternative plans, you should consult a financial professional or your plan administrator for plan limits.
Extensions on Deadlines for IRA Contributions
I applied for an extension to file my income tax return by October 17, 2020. Can I make my 2019 IRA contribution by October 17, 2020?
Tax-filing extensions do not apply to most retirement account contributions. SEP IRAs are one exception. In general, your retirement account contributions must be made by your tax-filing due date.
Deadline to Recharacterize IRA Contributions
I contributed $3,000 to my Traditional IRA for the last tax year. I recently met with my financial planner, who explained that I am eligible for a Roth IRA contribution for the last year and that it would be more beneficial to treat the amount as a Roth IRA contribution. Since I already filed my tax return by the due date of April 15, can I change the contribution to a Roth contribution now in July?
Yes. Since you filed your tax return by the due date, you receive an automatic extension of six months to recharacterize your IRA contribution from last year. This means your IRA custodian must receive your instructions for the recharacterization by October 15 of the current year. Be sure to check with the custodian to determine proper documentation requirements.
Since you already filed last year's tax return, and it did not include the recharacterization, you must file an amended tax return (IRS Form 1040X). Generally, Form 1040X must be filed within three years after the date you filed your original return or within two years after the date you paid your income tax, whichever is later. If you filed your tax return early, it is still treated as having been filed by your tax return due date. You should check with your tax professional or your state tax-filing authority to determine whether you need to file an amended state tax return.
The SECURE Act
Small business owners should know that in early January 2020, President Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. A component of the SECURE Act offers small businesses additional tax incentives to set up automatic enrollment in retirement plans for its workers or allows them to join multiple employer plans, where firms can join with other companies to offer retirement accounts to their employees. The bill also eliminates the maximum age cap for contributions to traditional IRAs.
Under the SECURE Act, employers no longer have to share “a common characteristic,” such as being in the same industry, when they set up an MEP. Employer-sponsored retirement plans can now be available to long-term part-time workers with a lower minimum number of hours worked. The SECURE Act means that workers with either one full year with 1,000 hours worked or three consecutive years of at least 500 hours are eligible for retirement plans.
We hope you found these questions and answers helpful. Bear in mind, however, that the information above gives only general guidelines for some basic scenarios and should not be taken as tax advice, legal advice, financial planning services, or estate-planning services.