Updated: Apr 23, 2021
Self-Directed Solo 401(k)s, among other retirement plans, allow the account holder to make salary deferral contributions each year. In 2020 the annual limit is $19,500 for those under 50 years old or $26,000 for those 50 and over. (More information about salary deferral and profit-sharing contribution calculations can be found here.) What happens, however, if the account holder’s salary deferral contribution is more than the amount allowed?
When looking at the amount that can be contributed as salary deferral, it’s important to understand that the $19,500 (or $26,000), limit must be aggregated across all plans that the account holder contributes to since it is calculated per individual, not per plan. For example, if a 40-year-old account holder is contributing $10,000 to their W-2 employer-sponsored group 401(k) plan and has a side business that sponsors a Self-Directed Solo 401(k), they can only contribute $9,500 to the second plan.
Any salary deferral amount that exceeds the limit is called an “excess deferral”. Excess deferrals, and any earnings on it within the taxable year, can be taxable income to the account holder if it is not corrected in a timely manner.
Correcting excess deferrals:
To correct the excess deferral, the account holder will need to distribute the excess deferral (and its earnings), by the due date of their tax return.
Consequences if the excess deferral is not corrected in a timely manner:
1 – The excess must be included in the account holder’s taxable income for the year in which the contribution was made, and
2 – the excess will be taxed a second time when the deferrals get distributed from the plan in the future.
Keep in mind, if the deferrals are not corrected and are instead left in the account, they become subject to the standard distribution rules otherwise applicable to retirement plans. Moreover, the account holder will not receive basis in the excess deferrals.
Keeping track of the salary deferral contributions for Self-Directed Solo 401(k)s is an important part of plan participation. While corrections can be made for excess deferrals, doing so promptly is vital to keeping the tax implications to a minimum.