MailBag: Solo 401(k) Contributions For S Corps And End-Of-Year Rebalancing To Harvest Capital Gains

Posted by Michael Kitces on Thursday, December 13th, 7:34 pm, 2012 in MailBag

Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I will occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis!) and my response, in the hopes that the discussion may be useful food for thought.

In this week's mailbag, we look at two recent inquiries: 1) when do employee "salary deferral" contributions have to be made for a solo 401(k) where the business is an S corporation; and 2) is it a good idea to split end-of-year rebalancing trades to trigger the gains this year but the losses next year (even if it means you're out of the markets for a few days).



Question/Comment: When do contributions to the solo 401(k)  have to be made by for S-corp? IRS pub 560 says:

"You generally apply your plan contributions to the year in which you make them. But you can apply them to the previous year if all the following requirements are met:
1.     You make them by the due date of your tax return for the previous year (plus extensions).

2.     The plan was established by the end of the previous year.

3.     The plan treats the contributions as though it had received them on the last day of the previous year.

4.     You do either of the following:

a.     You specify in writing to the plan administrator or trustee that the contributions apply to the previous year.

b.     You deduct the contributions on your tax return for the previous year. A partnership shows contributions for partners on Schedule K (Form 1065), Partners' Distributive Share Items."

Do you know if this is the case for both employer and employee contributions?

The text quoted here is a reference to the employer portion of S corporation retirement plan contributions, which can be made by the filing date for the tax return and be attributed to the prior year (just like any business’ profit-sharing contribution, or an individual’s IRA contribution for that matter).

The portion attributable to employee salary deferrals, however, must be done in a timely manner to the deferral – i.e., before or as of when the compensation is earned, and funded when compensation is (deemed) paid. In the context of traditional 401(k) plans, this ensures employee salary deferrals are really put into the employee's retirement account; when the employee is paid in January, then the January 401(k) contribution goes in (the technical rule is “as soon as reasonably possible, but in no event later than the 15th day of the following month”). This repeats throughout the year. 

With a solo 401(k), this rule still applies, even though "all" the money ultimately comes from the same place. The owner's compensation is deemed to have been earned at the end of the year on December 31st, but that still means the deferral must be made as of the end of December... which, accordingly, means the money must then find its way into the retirement account by January 15th (or as soon as reasonably possible). 

Notably, for an unincorporated Schedule C business, the deadline on salary deferrals actually is the tax filing date (same as the "employer" contribution), but that doesn't apply for S corporations, which have to follow the aforementioned rules instead.

Question/Comment: Given the capital gains harvesting strategies you've discussed in the past, then it seems that all other things being equal, if there’s a need to rebalance:

1. Harvest gains the last week (day) of December

2. Harvest losses in the first week (day) of January

3. Sitting in cash for a few days for a few classes shouldn’t be that detrimental

Do you agree? Should we run a position/rebalance report, and find clients that it would work for?

Indeed, this certainly fits within the general “gains harvesting” framework, where it makes sense if the outcome from Congress is that capital gains rates will rise (either because fiscal cliff “happens” or because a capital gains increase is written into a new compromise law, or simply because the client has high enough income that the new Medicare 3.8% surtax on unearned income will apply).

The biggest caveat is that while it can make sense to harvest the gains before the end of the year (albeit waiting until the latest point possible to see if a fiscal cliff compromise occurs), I suspect few or none of the loss transactions will occur in January, at least as a rebalancing trade. After all, if the position has declined, it probably needs to be PURCHASED for a rebalancing trade (i.e., it’s down, buy more), not bought.

Of course, if there's a loss, it's still an option to simply harvest the loss in January, but I wouldn’t do so just for the sake of harvesting losses; you can always sell later in 2013 (or at the end of 2013) if you still want/need to harvest losses then. Harvesting them early takes away flexibility (as those who harvested losses earlier this year have discovered, now that they can’t harvest gains without netting them against losses they didn’t actually want/need).

So in the end, it may well make sense to rebalance the stuff that has gains before the end of the year. Similarly, if you're considering an investment change anyway, it may be more appealing to do it before the end of the year, to deliberately try to recognize gains at this year's rates if it looks like we're going off the fiscal cliff and will have higher capital gains rates next year. But ultimately, as long as we tend to sell what's up and buy what's down, you probably won't be triggering many loss rebalancing trades with this strategy (not that you need to, either).


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