I have a two questions on how interest earned in my 401k Trust non-taxable master account affects my taxes and accounting. First, specifically, is the tax basis based upon transactions from my business account to the 401k master account, or from the 401k master account to the participant accounts?
Here are the details:
I am a sole proprietor with one employee (not myself) and a 401k. Funds flow from my business bank account to my Schwab brokerage 401k master account, then to the brokerage participant accounts (owner and employee). My employee makes small salary deferrals biweekly that I route to the master account and then the employee's participant account. The amounts are modest, and generally sit in the master account for less than 2 weeks before transferring to the participant account, and never are great enough to earn interest. I don't pay myself regularly, just by irregular draws on the profits. At the year end I figure my business profit, and have been fortunate to be able to make the maximum allowable deferral, match, and profit sharing for myself, and match my employee's contribution and make a proportional profit sharing contribution on her behalf. So once (or twice if I separate my deferral from my match and profit sharing) a year I make a large transfer to my master account, which earns a modest amount of interest before it is allocated among the owner and participant accounts, especially as it may sit there for a few weeks while I am finalizing my tax accounting to determine the profit sharing amount.
I use the interest earned on the master account to defray part of the cost to my business account for the next employee or owner deferral or other contribution. I pay slightly less tax if I allocate this interest toward owner deferrals rather than employee deferrals, as the owners deferrals are not deductible as a business expense as a sole proprietor, and hence I can fully deduct the employee deferrals slightly lowering my business income and hence self employment taxes.
I have not been able to find any guidance on IRS websites as to which transactions to use for my tax-basis, the transfers from by business account to the master account, or the transactions from the master account to the participant accounts. These transactions differ by the amount of interest earned in the master account.
To date, I use transfers from my business account to the 401k master account as the tax-basis transactions, not the transfers from the master account to the participant accounts. This results in a slightly smaller Form 1040 adjustment for self-employment qualified plan contributions than the actual owner total contribution for the year, as part of that contribution comes from interest accrued in transit while sitting in the master account. This raises my taxable income slightly compared to if I chose to use transfers from my master account to the participants accounts.
I have wondered whether I could instead use transfers from the master account to the participant accounts as my tax basis instead.
My rationale for not doing this to date is based upon an imagined scenario as follows: My 401k plan allows for 3 year cliff vesting of profit sharing contributions to employees. If an employee were to leave before vesting, the profit sharing contributions are forfeited back to the master account and can be used to defray the business (or personal sole proprietor) expense of future profit sharing contribution obligations. Were I to allocate these forfeited never income-taxed profit sharing amounts to my future owner profit sharing, if I used transfers from the master to participant account as my tax basis - it would result in a current year personal income adjustment against taxes a second time, which would seem to be contrary to the intent that these funds are tax deferred once at the time of original contribution, rather than twice, and taxed only once upon future distribution out of the retirement account.
OK, so I have talked myself into using transactions from my business account to my 401k master account as those for my tax-basis.
So the second question is this:
Can I make a maximal 401k owner contribution from my business account to my master account, and then transfer the additional interest earned in the master account and transfer it into the owner's participant account, which would be slightly larger by the amount of interest earned in transit than the maximum allowable 401k contribution per year, treating it as if the interest had been earned instead inside the owner's participant account?
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