Solo 401k Plan Contributions | Net Earnings from Self-Employment

An Individual seeking to open a solo 401k need to first thoroughly determine if he or she qualifies to open a solo 401k plan and then determine what amounts of income qualify as self-employment income that can be used towards determining to annual solo 401k contribution.  

 An individual’s earned income is his or her net earnings from self-employment [as defined in IRC 1402(a)] with the modifications described in IRC 41(c). All adjustments taken into account in arriving at net earnings from self-employment tare made, even if the self-employed individual separately reports such items.

How to Compute Net Earnings from Self-Employment

The starting point for determining net earnings from self employment for solo 401k plan contribution purposes will be: 

The Schedule C (line 31) or Schedule C-EZ (line 3), in the case of most sole proprietors,

The Schedule K-1 (line 15a), in the case of partners of partnerships (or entities, such as LLCs, which are taxed as partnerships), or

The Schedule F (line 36) for farming operations.

Subsequently one must make any adjustments required by IRC 401( c )(2) as follows:

Only earnings from a trade or business in which the individual’s personal services are a material income-producing factor are included. In other words, if investment income (e.g., interest) is passed through the partnership to the partners, that income is not included in earned income. Similarly, a partner that is involved in the partnership as an investment only and is not active in the business operations would have no earned income. 

Self-employment tax deduction under IRC 164(f). Earnings are reduced by the deduction allowed under IRC 164(f) for on-half of the individual’s self-employment.

Reduction of earned income for self-employed individual’s qualified plan deduction. 

Earnings are reduced by the deductions allowed to the individual under IRC 404 for contributions to a solo 401k plan, including contributions allocated for the benefit of the self-employed individual. For example, if an individual’s earned income without a qualified plan deduction would be $60,000, but the IRC 404 deduction is $10,000, the individual’s earned income is only $50,000. The $50,000 amount must be determined whether the contribution allocation exceeds any limitations, such as the IRC 415 limitation or the deduction limitation under IRC 404. The $50,000 amount is also used to determine whether the contribution satisfies the nondiscrimination requirement of IRC 401(a)(4).

When the employer is a sole proprietorship, the entire IRC 404 deduction for the year will reduce the earned income of the sole proprietor. When the employer is a partnership, the IRC 404 deduction is allocable among the partners. Thus, for each partner’s allocable share of the IRC 404 deduction relating to the common law employees and the portion of the IRC 404 deduction attributable to contributions made on behalf of the partner. 

Personal Services Must Be Actually Rendered

Earned income only includes net earnings derived from the individual’s personal services. Gains (other than capital gains) and net earnings derived from the sale or other disposition of property, or the licensing of the use of property, constitutes earned income of the individual’s personal efforts created such property.  

Once you determine your net-income figure as described above, visit solo 401k contribution calculator to finish calculating your 2012 or 2013 and future year’s solo 401k contribution limits.

·