Proper calculation of a self-employed person’s retirement plan deduction

By | December 6, 2015

Proper calculation of a self-employed person’s retirement plan deduction can be really difficult. We had kind of planned on this being a really more involved discussion of it, but we had so much that came out new this year that the slide on this kept getting smaller, and now it’s kind of tiny. During my audit days, I did not look forward to the audits involving self-employed plan sponsors, but I frequently ran across them.


Self-Employed Retirement Plans

Many had trouble with the calculation for the owner’s contribution and that related deduction, and I’ll say I also had trouble with it. It can be kind of difficult and with such a large group of people and only part of an hour, it’s going to be almost impossible to keep everybody awake to do a complete discussion. So, what we’re going to do is talk about some of the issues that we would see on audits mainly.


IRS Issues with Self-Employed Retirement Plans

First, the number one issue really had nothing to do with the self-employed plans. These plans had the same issue that we regularly find. Nearly half of them that I had seen had not been timely amended for these required law changes. Now, the majority of these really small plans use pre-approved plan documents. And remember you have until April 30, 2016, to update those pre-approved prototype documents on these defined contribution plans – that’s profitsharing and 401(k)-type plans.


Common Issues on IRS Audits of Self-Employed Retirement plans.

Now, another common issue we saw was also just leaving employees out of the plan that had met the eligibility requirements. Self-employed plans do tend to be very small employers, and I think a lot of times they look at some of their people as part-time employees and they don’t realize how easy it is to meet the plan’s eligibility requirements. All they have to have is 1,000 hours.


Taking Deduction on Self Employed Retirement Plan

The question is where should you take the deduction for contributions to the plan? I know that’s been kind of an issue also. For the employees that are participants in the plan, these are the employees, the contributions are deducted on the owner’s Schedule C. For the owner, the deduction for a contribution to them was taken on page one of the Form 1040. That’s kind of the easy part really; it’s just getting to that contribution amount that can be a little tricky. Now, to calculate the plan compensation for that owner, you get to reduce their net earnings from self-employment by the deductible portion of the self-employment tax from page one of the Form 1040 and also the amount of the contribution made for the owner.


Owner’s Contribution to Retirement Plan

The amount of the owner’s contribution is dependent on how much the owner is contributing on their own behalf. It’s a real circular calculation here, and there are a couple of methods that you can use to find that amount. One way is you can use the rate table that is in Publication 560, or you can compute the reduced plan contribution rate yourself. You do that by dividing the plan contribution rate by one plus the plan contribution rate.


Example of Owner’s Contribution to Retirement Plan

For example, if the rate the other employees received was 10 percent, you divide 0.10 by 1.10 and you get the owner’s contribution percentage of 9.0909 percent. You take the Schedule C net profit, deduct half the SE tax and you multiply that by 9.0909 percent to find the amount of the owner’s contribution in that little example.