In Retirement News For Employers, August 20, 2013, the IRS provides guidance on how self-employed individuals should calculate their own retirement plan contributions and deductions. Here is what the IRS said:
If you are self-employed (a sole proprietor, or a working partner in a partnership or limited liability company), you calculate your self-employment ("SE") tax using the amount of your net earnings from self-employment and following the instructions on Schedule SE, Self-Employment Tax. However, you must make adjustments to your net earnings from self-employment to arrive at your plan compensation, which is the amount you use to determine the plan contribution/deduction for yourself.
To calculate your plan compensation, you reduce your net earnings from self-employment by:
-- the deductible portion of your SE tax from your Form 1040 return, page 1 (Schedule SE, IRC Sections 401(c)(2) and 164(f)); and
-- the amount of your own (not your employees') retirement plan contribution from your Form 1040 return, page 1, on the line for self-employed SEP, SIMPLE, and qualified plans (IRC Section 401(c)(2)).
You use your plan compensation to calculate the amount of your own contribution/deduction. Note that your plan compensation and the amount of your own plan contribution/deduction depend on each other - to compute one, you need the other (this is a circular calculation). One way to do this is to use a reduced plan contribution rate. You can use the Table and Worksheets for the Self-Employed (Publication 560) to find the reduced plan contribution rate to calculate the plan contribution and deduction for yourself.
Joe, a Schedule C sole proprietor, will have $100,000 net profit on his 2013 Schedule C (after deducting all Schedule C expenses, including a 10% retirement plan contribution made for his common-law employees but not his own contribution). Joe must pay $14,130 in SE taxes. To compute his plan compensation, Joe must subtract from his net profit of $100,000:
-- the IRC Section 164(f) deduction, which in this case is ½ of his SE tax ($14,130 x ½);
-- the amount of contribution for himself to the plan.
To determine the amount of his plan contribution, Joe must use the reduced plan contribution rate (considering the plan contribution rate of 10%) of 9.0909% from the rate table in Pub. 560.
Alternatively, Joe can compute his reduced plan contribution rate by:
1. Taking the plan contribution rate 10%
2 .Dividing the plan contribution rate by 100% + plan contribution rate 10%/110%
3. To get the reduced plan contribution rate 9.0909%.
Joe can now compute his own contribution/deduction amount as follows:
1 .$100,000 Schedule C net profit
2. - $7,065 1/2 SE tax deduction ($14,130 x ½)
3. = $92,935 Net profit reduced by ½ SE tax
4. x 9.0909% Joe's reduced plan contribution rate
5. = $8,449 Joe's allowed contribution and deduction
There is simple way to quickly verify the accuracy of Joe's contribution/deduction amount:
1. $100,000 Joe's Schedule C net profit
2. - $7,065 ½ SE tax deduction
3. - $8,449 Joe's contribution/deduction for himself
4. = $84,486 Amount subject to plan's full rate
5. x 10% Plan's full rate
6 = $8,449 Joe's contribution/deduction for himself
If lines 3 and 6 above match, the contribution/deduction calculation is correct.
Contribution or deduction mistakes
You should amend your Form 1040 tax return and Schedule C if you:
-- deducted your own plan contribution on Schedule C instead of on Form 1040, page 1,
-- made and deducted more than the allowable plan contribution for yourself.
If you contributed more for yourself than your plan terms allowed, you should also correct this plan qualification failure by using the IRS correction programs.