Solving the Complexities of Calculating Self-Employed Retirement Plan Contributions
By Lisa Haberman, MBA, MAM, ChFC, CLU
For self-employed individuals, determining the amount that can be contributed to a qualified plan can be daunting. To address this intimidating task, it is important to understand that the compensation that can be used to calculate a retirement plan contribution is likely to be a different amount than what is reported to the Internal Revenue Service (IRS) as net earnings (profit or net business income) for tax purposes. There are several steps to consider when converting net earnings reported to the IRS into the actual amount of compensation available for determining a contribution into the plan. However, there is guidance to help self-employed individuals sort through the complexities of this onerous task. Here are a few key concepts to get started.
Defining Earned Income
Self-employed individuals may make contributions to a retirement plan only if they have net earnings from their activities in the trade or business for which the plan was set up. If an individual has more than one business entity, but only one retirement plan, it’s possible that only the net earnings from the business that sponsors the qualified plan will be included in the calculation for contributions to that plan. The plan’s document language will determine whether a “related employer” is automatically included in the plan. If the self-employed individual owns more than one business outright—or to a sufficient degree—the businesses would constitute a “controlled group” of businesses, and consequently all—including the individual’s compensation from all—would be covered under the plan. In addition, net earnings must be derived from personal services (not investment income) performed by the self-employed individual. Therefore, if the trade or business operates at a loss for the year, the self-employed individual will not be able to contribute to the plan.
If a self-employed individual is considered a partner in a business entity (e.g., a limited liability company (LLC) or limited partnership (LP)), the individual’s income must be received for services that materially helped produce the income. It’s possible that not every partner provides personal services that materially produces income for the business. For example, a limited partner may provide investment capital to the business entity. In this case, any revenue generated from the business will not be considered eligible compensation for the limited partner as he did not provide a personal service that materially produced income for the firm.
For retirement plan contribution purposes, self-employed individuals take the gross income generated from their trade or business and then subtract any allowable business deductions when determining net earnings (profit). Permitted deductions include contributions to a plan for common-law employees and the deductible portion of self-employment tax. Net earnings are reported on one of three tax forms, depending on the individual’s type of self-employment.
Sole Proprietor – Schedule C (attachment to IRS Form 1040)
Farmers – Schedule F (attachment to IRS Form 1040)
Partners/Partnerships – Schedule K-1 (attachment to IRS Form 1065)
Self-employed individuals must use the net earnings (profit) as reported on the appropriate schedule (Schedule C, Schedule F, or Schedule K-1) to also calculate self-employment tax by completing Schedule SE. Self-employment tax is similar to the tax paid for most wage earners, consisting of Social Security and Medicare taxes for individuals who work for themselves.
Once these tax forms are completed, a self-employed individual has the information needed to start the calculation to determine the amount of compensation available for plan contribution purposes.
First Steps to Calculate Plan Compensation
For sole proprietors and farmers, the calculation to determine plan compensation starts by reducing their net earnings by the deductible portion of self-employment tax and the amount of the self-employed individual’s contribution to a retirement plan. For partners/partnerships, the plan compensation calculation starts by subtracting from self-employment earnings one-half of the partner’s self-employment tax as well as a partner’s contributions into a plan.
These calculations are complex because the self-employed individual must determine how much of a plan contribution is being made in order to calculate the amount of plan compensation. And, in order to calculate the amount of plan compensation, the self-employed individual must also know the amount of the plan contribution. The IRS refers to this as a circular calculation. One way to address this issue is to use a reduced plan contribution rate. The IRS provides a rate table and worksheet in chapter 5 of Publication 560 to assist in determining the reduced plan contribution rate needed to calculate the plan contribution and deduction for self-employed individuals. The IRS also provides an example of completing the circular calculation at Self-Employed Individuals – Calculating Your Own Retirement-Plan Contribution and Deduction. The calculation is more complex if the self-employed individual also has common law employees.
Next Steps
We’ve only addressed the first steps in calculating plan compensation. Of course, every self-employed individual will have unique circumstances that affect the calculation of their net earnings and self-employment tax – which make these calculations even more complex. Many self-employed individuals rely on the expertise of competent tax professionals or certified public accountants to complete the detailed calculations and necessary tax forms that permit then to make an accurate annual contribution to their qualified plan.
