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Do S-Corporation Distributions count for 401k & Pension Plans?

14 Aug
401k

Do S-Corporation Distributions count for 401k & Pension Plans?

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S-Corps, Distributions, W-2 Wages, Self-Employment Tax, 401k & Pension Plans & their interaction – it’s all about balance. So, you’ve talked to your accountant & they tell you to minimize your W-2 wages to limit your self-employment taxes. Then, you talk to your investment advisor and they explain the advantages of tax-qualified retirement plans such as 401k, cash balance & defined benefit plans and the opportunity for significant tax savings. Life is great, right?

So, what’s the problem?

It’s all about “earned income” under IRS rules. By that, I mean that distributions to a S-Corporation shareholder shall not be considered for a qualified plan as they are not deemed earned income by the IRS.

It’s about balance

Below is a very simple example which defers 20% of compensation (that only counts W-2 salary). You’ll see that as W-2 wages increase, the Self-Employment tax will significantly increase. However, if you’re looking to defer significant income, the potential tax savings from that increased tax deferral can largely mitigate the increases in Self-Employment Tax.

Full Pay Mid-level Pay Minimize Pay
W-2 Salary $270,000 $175,000 $100,000
Distributions $105,000 $200,000 $275,000
Total income $375,000 $375,000 $375,000
Self-Employment Tax (employee + employer) $23,603 $20,848 $15,300
401(k) Deferrals $18,000 $18,000 $18,000
Profit Sharing $36,000 $17,000 $2,000
Total Tax Deferral $54,000 $35,000 $20,000
Income Tax Savings @ 40% Marginal Tax Rate ($21,600) ($14,000) ($8,000)
Self-Employment Tax less Income Tax Savings $2,003 $6,848 $7,300

So, what’s the right answer?

It largely depends upon your goals (are you looking to defer sizable amounts of income or is the plan largely for your employees?), your tax rate and the stability of your income. As always, we suggest you consult your accountant, tax advisor and investment professional to review your options.

If you have questions about how to best design your retirement plan including a 401(k), please give us a call at (855) 401-GAIN (4246) and press option 1, complete a form or email us at hello@odysseyadvisors.com.

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