This page describes a composite hypothetical. It is not a real client or a real result. Contribution limits are indexed and change every year, so the limits below are assumptions used only for arithmetic. Confirm the current figures with a plan provider.
The Scenario in Brief
An independent consultant operates through an S corporation and has no employees. The consultant pays a salary through payroll and takes the rest of the profit as distributions. The consultant wants to save more for retirement and has heard that a solo 401(k) can be more flexible than a SEP IRA. The consultant asks an advisor how much could be contributed and how the salary would affect it.
Assumptions Used
- W-2 salary paid by the corporation: 100,000 dollars.
- Assumed annual limit on employee elective deferrals: 24,000 dollars. The actual limit is indexed and may include catch-up amounts for older participants.
- Assumed employer contribution: 25 percent of W-2 wages, so 25,000 dollars. The plan document sets the actual rate, and the deduction limit is generally a percentage of eligible compensation.
- Assumed overall annual limit on total contributions: 70,000 dollars, which is not reached in this example.
- An assumed marginal federal rate of 24 percent is used for illustration.
- The consultant is under 50 and has no catch-up contribution.
Worked Arithmetic: The Two Buckets
| Item | Amount |
|---|---|
| Employee deferral from salary (assumed limit) | 24,000 dollars |
| Employer contribution: 25 percent of 100,000 | 25,000 dollars |
| Total contribution | 49,000 dollars |
| Salary reported in box 1 of Form W-2 after deferral | 76,000 dollars |
| Illustrative federal income tax reduction at an assumed 24 percent | about 11,760 dollars |
The deferral is subject to payroll tax, because elective deferrals reduce income tax wages but not Social Security and Medicare wages. The employer contribution is generally not subject to payroll tax and is deductible by the corporation. The illustrative tax reduction is arithmetic on assumptions and ignores the qualified business income deduction, state tax, and other items.
The Salary Question
The advisor would point out that the salary drives both contribution buckets. A higher salary would allow a higher employer contribution and would also make room for the deferral, but it would increase payroll tax. Suppose the consultant considered raising the salary to 120,000 dollars.
| Item | Salary of 100,000 dollars | Salary of 120,000 dollars |
|---|---|---|
| Employee deferral (assumed limit) | 24,000 dollars | 24,000 dollars |
| Employer contribution at 25 percent | 25,000 dollars | 30,000 dollars |
| Total contribution | 49,000 dollars | 54,000 dollars |
| Payroll tax on salary at 15.3 percent | 15,300 dollars | 18,360 dollars |
| Difference in payroll tax | 3,060 dollars | |
| Difference in contribution | 5,000 dollars |
The extra 5,000 dollars of contribution costs an additional 3,060 dollars of payroll tax in this simplified model, before considering the deduction for the employer share of payroll tax and the effect on the qualified business income deduction. The advisor would explain that this trade-off is one reason retirement goals belong in the salary conversation, and that the answer depends on the consultant's priorities. A reasonable salary must be supportable independent of the retirement plan. Raising salary solely to increase contributions is not a substitute for a defensible compensation analysis.
Roth Option
The advisor would ask whether the plan should include a Roth deferral feature. If the consultant expects to be in a higher bracket in retirement, or wants tax-free growth, some or all of the deferral could go to the Roth option, in which case the contribution would not reduce current taxable income. The trade-off is between current tax reduction and potential future tax-free withdrawals, subject to the rules.
Deadlines and Setup
The advisor would remind the consultant that elective deferrals generally must be elected before the end of the year in which the compensation is earned, and that the employer contribution can generally be made up to the corporation's tax filing deadline, including extensions. Setting up the plan in the fall gives time to complete paperwork and to run payroll deferrals for the remaining pay periods. The advisor would also mention that once plan assets exceed a threshold, an annual information return is generally required.
Scenario Variations Worth Considering
If the consultant were over 50, the catch-up contribution would add to the deferral. If the consultant hired an employee, the plan might need to cover that person. If the consultant's profit were much lower, the salary and contributions would be smaller. If the consultant preferred simplicity, a SEP IRA might be considered, with a lower total capacity at this salary.
Risks and Limits
- Limits change each year and are assumptions in this scenario.
- Contributions reduce cash available for the business.
- Salary must be reasonable regardless of the plan.
- Plan documents and filings must be maintained.
What This Scenario Teaches
Retirement contributions for an S corporation owner are built on W-2 salary. The interaction between salary, payroll tax, and contribution capacity makes it worth modeling both together.
Questions to Bring to Your Advisor
- What are the current limits for my plan and age?
- How does my salary affect my contribution?
- Should I use the Roth feature?
- When are the deadlines for my plan?
Frequently Asked Questions
Are the contribution limits in this scenario current?
No. They are assumptions for arithmetic. Confirm the current limits.
Can I set my salary based on what I want to contribute?
Salary should be reasonable for the services performed. The retirement plan should follow the salary, not the reverse.
Want to Talk Through Your Own Situation?
These scenarios are illustrations only. Book a discovery call with AE Tax Advisors to discuss the facts of your own business or portfolio.
Book a Discovery CallEducational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.