Do S-Corporation Distributions Count For 401k & Pension Plans?

August 14, 2017|Parker Elmore

Updated June 8, 2021

Key Points

  • Short answer – no. Contributions to a retirement plan may only be made from your W-2 wages/earned income.
  • Your retirement plan contributions are based solely on your W-2 wages and NOT on the flow-through income.
  • Please consult with your accountant, tax advisor, and investment professional to review your compensation and go over specific options based on your situation.

S-Corporation owner collaborating with key stakeholders pointing to a computer monitor
Photo by Leon on Unsplash

So you’re the owner of a corporation taxed as an S-Corporation. You’ve been careful and worked with your accountant to limit your W-2 wages to save on self-employment taxes while also being cognizant of the IRS rules related to reasonable compensation.

As you consider adding a retirement plan or find a way to take advantage of the one you currently have, please keep in mind that your limited W-2 wages will also limit your ability to contribute to the retirement plan. It’s all about balance. Your accountant is telling you to minimize your W-2 wages while your investment advisor reviews the advantages of tax-qualified retirement plans such as 401k, cash balance, and defined benefit plans plus the opportunity for significant tax savings. That all sounds great and life is good, right?

So, what’s the catch?

It’s all about “earned income” under IRS rules. Distributions to an S-Corporation shareholder shall not be considered for a qualified plan as they are not deemed earned income by the IRS. They state that any contributions made to a retirement plan can only be made from your earned income as a self-employed individual.

It’s about balance

Below is a simple example of a business owner with $400,000 in total pay (W-2 wages plus S-Corp distributions). They defer 20% of W-2 income split between employee and employer contributions. You can see here that as their W-2 wages increase, the self-employment tax significantly increases. However, the total tax burden increases in the mid-level W-2 scenario but declines materially in the max-level scenario as the income tax savings dwarf the increasing self-employment taxes.

S-Corporation owner tax savings comparison table at various W-2 income levels

So, what’s the right answer?

It largely depends upon your goals, your tax rate, and the stability of your income. Are you looking to defer sizable amounts of income or is the plan largely for your employees? Every company and situation is different. Please consult your accountant, tax advisor, and investment professional to review all of your options. They should be able to help you assess your compensation and retirement plan options based on your situation.

If you have any questions on this or need more advice, please reach out to one of our Odyssey consultants. No strings or sales pitch attached. You can also fill out the contact form below.

Categories: 401(k), Pension, Retirement