Figuring a Self-Employed Person's Deductible Contributions

As a self-employed person, like your employees, you may also make before-tax contributions to a 401(k) plan.

However, determining your own deductible contribution as a self-employed person is not as straight forward as determining contributions made on behalf of employees.

To determine an employee's contribution:

  • Multiply the employee's compensation (e.g., wages, salary) by the contribution rate stated in the plan.
    • For example, if an employee's gross pay is $20,000 and the plan rate is 10%, the contribution is $2,000 (10% x $20,000).

However, as a self-employed person you must determine:

  • Your correct compensation amount to be used in figuring your own deductible contribution and
  • Your correct contribution rate (which is not the same rate stated in the plan that is used for employees; your contribution rate will be lower).

If you're self-employed you deduct contributions for yourself on Form 1040, line 28.

Special Computation for Self-Employed Persons

Because you must determine the correct compensation to be used to figure your deductible contribution, as well as your reduced contribution rate, this requires a little adding, subtracting, and multiplying.

To figure your deductible contribution is a three-step process:

  • Figure your net earnings from self-employment
  • Figure your reduced contribution rate
  • Multiply your net earnings from self-employment by your reduced contribution rate to determine your deductible contribution

The following information explains the elements of the three-step process. On the next page, after the explanation is complete, an example is presented to show you how to do the computation.

STEP 1:

Figure your net earnings from self-employment.

Net earnings from self-employment equals:

  • Net profit on Schedule C, line 31 (or F), reduced by one-half of your self-employment tax liability, which is deducted on Form 1040, line 27.

REMINDERS:

  • Contributions for employees:
    • Make sure you already deducted contributions you made on behalf of your employees (if any) on Schedule C, line 19 before you start figuring your own deductible contribution.
      • As an employer, you can make either matching or nonelective contributions on behalf of your employees.
  • Contributions for yourself:
    • Remember, contributions made for yourself are NOT entered on Schedule C; deduct them on Form 1040, line 28.
  • Partners and LLC members (where the LLC is taxed as a partnership, which is usually the case):
    • Schedule K-1 is issued annually to each partner. It reports each partner's share of partnership and LLC net income, deductions, credits, and losses.
    • Like a sole proprietor, each partner or LLC member must subtract one-half of his self-employment tax liability from his share of net income reported on Schedule K-1 to determine net earnings from self-employment.
    • Each LLC member and partner deducts contributions for himself/herself on Form 1040, line 28.

STEP 2:

Figure your reduced contribution rate.

Your compensation, for purposes of determining your own deductible contribution, takes into account:

  • The deduction for one-half of your self-employment tax and
  • The deduction for contributions on your behalf to the plan (which is unknown when you start the computation).

Reminders:

  • Your reduced plan rate:
    • Since your deduction for your own contributions and your net earnings depend on each each other, you determine your deductible contributions indirectly by reducing the rate stated in the plan document.
  • The stated plan rate:
    • The contribution rate stated in the plan document applies to employees only, NOT YOU as a self-employed person.

STEP 3:

Multiply net earnings from self-employment by your reduced contribution rate to determine your deductible contribution.

Maximum percentage:

The maximum deductible percentage for contributions (other than elective deferrals) to your own profit-sharing Keogh, money-purchase Keogh, or SEP is 20% and for your employees, 25%.

Publication 560 table and worksheets:

You can also use the Table and Worksheets for the Self-Employed to figure your deductible contribution.

Example:

Figuring Your Deductible Contribution if You're Self-Employed:

Here are the facts:

  • The plan rate is 10% (.10).
  • Your a Schedule C filer
  • Schedule C, line 31 shows a net profit of $40,000.
  • Form 1040, line 27 shows a $2,826 deduction for one-half of your self-employment tax liability.
    • Schedule SE was used to figure your self-employment tax.

Step 1:

Figure your net earnings from self-employment.

Your net earnings from self-employment is $37,174, figured as follows:

  • $40,000 (Schedule C, net profit) minus $2,826 (one-half of self-employment tax) = $37,174

STEP 2: Figure your reduced contribution rate.

Your reduced contribution rate is .090909, figured as follows:

  • Use the plan rate as the numerator (.10 in the example)
  • Add 1 to the plan rate to determine the denominator:
    • 1 + .10 = 1.10
  • Divide the plan rate by 1 plus the plan rate to find your reduced rate:
    • .10/1.10 = .090909

STEP 3: Multiply net earnings from self-employment (STEP 1) by your reduced contribution rate (STEP 2) to determine your deductible contribution.

Your deductible contribution is $3,379, figures as follows:

  • $37,174 (STEP 1) x .090909 (STEP 2) = $3,379

STEP 2:

Figure your reduced contribution rate.

Your compensation, for purposes of determining your own deductible contribution, takes into account:

  • The deduction for one-half of your self-employment tax and
  • The deduction for contributions on your behalf to the plan (which is unknown when you start the computation).

Reminders:

  • Your reduced plan rate:
    • Since your deduction for your own contributions and your net earnings depend on each each other, you determine your deductible contributions indirectly by reducing the rate stated in the plan document.
  • The stated plan rate:
    • The contribution rate stated in the plan document applies to employees only, NOT YOU as a self-employed person.

STEP 3:

Multiply net earnings from self-employment by your reduced contribution rate to determine your deductible contribution.

Maximum percentage:

The maximum deductible percentage for contributions (other than elective deferrals) to your own profit-sharing Keogh, money-purchase Keogh, or SEP is 20% and for your employees, 25%.

Publication 560 table and worksheets:

You can also use the Table and Worksheets for the Self-Employed to figure your deductible contribution.

Example:

Figuring Your Deductible Contribution if You're Self-Employed:

Here are the facts:

  • The plan rate is 10% (.10).
  • Your a Schedule C filer
  • Schedule C, line 31 shows a net profit of $40,000.
  • Form 1040, line 27 shows a $2,826 deduction for one-half of your self-employment tax liability.
    • Schedule SE was used to figure your self-employment tax.

Step 1:

Figure your net earnings from self-employment.

Your net earnings from self-employment is $37,174, figured as follows:

  • $40,000 (Schedule C, net profit) minus $2,826 (one-half of self-employment tax) = $37,174

STEP 2: Figure your reduced contribution rate.

Your reduced contribution rate is .090909, figured as follows:

  • Use the plan rate as the numerator (.10 in the example)
  • Add 1 to the plan rate to determine the denominator:
    • 1 + .10 = 1.10
  • Divide the plan rate by 1 plus the plan rate to find your reduced rate:
    • .10/1.10 = .090909

STEP 3: Multiply net earnings from self-employment (STEP 1) by your reduced contribution rate (STEP 2) to determine your deductible contribution.

Your deductible contribution is $3,379, figures as follows:

  • $37,174 (STEP 1) x .090909 (STEP 2) = $3,379

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