“Several of my clients are self-employed and have 401(k) plans. What is the date by which a self-employed individual must make his or her salary deferral election?”
ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
A recent call with a financial advisor from Nevada is representative of a common inquiry related to 401(k) plan salary deferral elections.
Highlights of the Discussion
Special rules regarding salary deferral elections apply to self-employed individuals (e.g., sole proprietors or partners). They must make their cash or deferred elections no later than the last day of their tax year (e.g., by December 31, 2018, for a 2018 calendar tax year). The timing is connected to when the individual’s compensation is “deemed currently available” [see Treasury Regulation Section (Treas. Reg. §) 1.401(k)-1(a)(6)(iii)].
Often a self-employed individual’s actual compensation for the year is not determined until he or she completes his or her tax return, which, in most cases, is after the end of the partnership or individual’s taxable year. However, the IRS deems a partner’s compensation to be currently available on the last day of the partnership taxable year and a sole proprietor’s compensation to be currently available on the last day of the individual’s taxable year. Therefore, a self-employed individual must make a written election to defer compensation by the last day of the taxable year associated with the partnership or sole proprietorship.
A partner can make a cash or deferred election for a year’s compensation any time before (but not after) the last day of the year, even though the partner takes draws against his/her expected share of partnership income throughout the year.
There are also special rules that address when salary deferrals for self-employed individuals are treated as made to the plan (versus when they may actually be made). Treas. Reg. §1.401(k)-2(a)(4)(ii) states that an elective contribution made on behalf of a partner or sole proprietor is treated as allocated to the individual’s plan account as of the last day of the partnership or sole proprietorship’s taxable year.
With respect to the DOL’s deferral deposit deadline, deferrals for self-employed individuals must be deposited as soon as they can be reasonably segregated from the business’s general assets. The DOL’s safe harbor for plans with fewer than 100 employees also applies. Therefore, as long as the deferrals are transmitted within seven business days after the amounts are separated from the business’s assets, the contributions are deemed timely made.
From the IRS’ tax perspective, in no event can the deferrals be deposited after the deadline for filing the business’s tax return, plus extensions.
With respect to making a salary deferral election, a self-employed individual must do so no later than the last day of his or her tax year. The election should be documented in writing for proof in the event the plan later undergoes an audit. Therefore, those self-employed individuals following a calendar tax year must be sure to execute their written deferral elections by December 31, 2018!