How to calculate SIMPLE IRA contributions for the Self-Employed
If you’re confused about the SIMPLE IRA for the self-employed you have come to the right place.
There is a lot of confusion on the correct formula for the SIMPLE IRA contributions for the self employed because the IRS has contradictory information on their website, publications and tax codes.
I figured this out after using Intuit’s tax software, Pro-connect, for tax preparation (also known as the makers of TurboTax) and a SIMPLE IRA contribution calculator created by CalcXML. The calculator is used by a lot of financial institutions so if you search around there is a good change you’re using their calculator.
I have put together the documentation so you can see exactly how to calculate the SIMPLE IRA contributions for the self-employed.
The contributions for the SIMPLE IRA for the self-employed are a little different than contributions for other SIMPLE IRA contributions. If you’re an S-corp filer for tax purposes then the calculation for self-employed DOES NOT apply to you. If you are a sole-proprietor or Schedule C filer, then keep reading.
Here is an explanation of why there is so much confusion, where to find the correct information and why it must be wrong in Publication 560.
IRS Publication 560
The IRS puts together various publications as references and guidance for taxpayers and IRS agents. If you call the IRS, they will refer to these publications but it’s important to note, the publications are NOT tax law and neither is this blog.
According to IRS Publication 560 version 2019 for the SIMPLE IRA, chapter 3 page 9.
“If you are self-employed, compensation is your net earnings from self-employment (line 4 of Short Schedule SE (Form 1040 or 1040-SR), or line 6 of Long Schedule SE (Form 1040 or 1040-SR)) before subtracting any contributions made to the SIMPLE IRA plan for yourself.”
If this is true, then your SIMPLE IRA plan compensation is net profit multiplied by .9235 which is exactly what you would find on line 4 of Schedule SE. The .9235 is calculated by subtracting 1/2 the rate of self employment tax which is .153.
Unfortunately, this formula reduces your plan compensation more than the amount of deductible taxes. Meaning the amount you can contribute to a SIMPLE IRA would be reduced beyond net earnings.
How Self-Employment Tax is calculated
If you want to know why it’s reduced beyond net earnings then you need to understand how Social Security and Medicare taxes work.
Social security is 6.2% and medicare is 1.45% which equals 7.65% and are paid by both the employer and employee. This works out to a combined rate of 12.4% for social security and 2.9% for medicare. Add these two numbers up and you will get 15.3%.
The deducible portion of your self-employment tax is 1/2 of the self-employment tax of 15.3% which is 7.65%. 100% – .765 is .9235 or the number that you would find on line 4 of schedule SE.
The reason you would subtract 1/2 of self employment is because it’s a deductible business expense. The amount of your compensation is “net profits,” when you’re self employed. Said another way, your revenue minus expenses is your profit.
It would probably make more sense to have another line that just states “your compensation,” but when was anything easy when it came to the IRS or your taxes.
There is an additional .9% for medicare if you earn over $200,000 single and $250,000 married filing jointly, but this is not deductible and will not affect the calculations either way.
Why publication 560 is wrong
The first problem is the formula in publication 560 doesn’t take into consideration that social security is capped at $137,700 for 2020.
Publication 560 also contradicts several other page of the IRS website, FORM 5304-SIMPLE and the tax code. I’ll tackle each one of these so you can see why Publication 560 is wrong.
Problem #1 IRS Website
The IRS page for the SIMPLE IRA Plan FAQs – Compensation cites Internal Revenue Code section 1402(a) as the formula to calculate plan compensation. The same citation and formula that is also found on a similar page of the SEP Plan FAQs – Compensation.
I am pointing out the SEP IRA page because it’s the same formula used to calculate self-employment for the SIMPLE IRA, or at least according to the individual pages. The only difference is the SEP IRA is 100% employer funded whereas the SIMPLE IRA has employee and employer contributions.
Problem #2 FORM 5304-SIMPLE
One of the forms to setup the SIMPLE IRA is FORM 5304-SIMPLE and this too contradicts Publication 560.
“Compensation for Self-Employed Individuals. For self-employed individuals, compensation means the net earnings from self-employment determined under section 1402(a), without regard to section 1402(c)(6), prior to subtracting any contributions made pursuant to this plan on behalf of the individual.”
Problem #3 Section 1402(a)
The final issue is the formula referenced above uses tax code 1402(a) to calculate compensation. The formula for compensation according to section 1402(a) is Net Profit – 1/2 self employment tax.
I could not find anything in section 1402(a) or any subparagraph mentioning anything different about the SIMPLE IRA compensation formula for self-employed contributions.
It appears the IRS just cuts and pastes the publication 560 from year to year. It’s kind of puzzling why the IRS took so long to release the 2019 version when very few edits were found.
Table and Worksheet for the Self Employed
There is a worksheet for the self employed at the end of Publication 560 which may make you believe that it also applies to SIMPLE IRAs — that would be incorrect.
First, chapter 3 already contradicts using the worksheet. Second, in chapter 1 of publication 560, the SIMPLE IRA says,
“SIMPLE plans. A special definition of compensation applies for SIMPLE plans. “
And lastly, chapter 5 says,
“As discussed in chapters 2 and 4, if you are self-employed, you must use the rate table or rate worksheet and deduction worksheet to figure your deduction for contributions you made for yourself to a SEP-IRA or qualified plan. “
SIMPLE IRA Contribution Formula for the Self-Employed
The formula used in Chapter 5 of publication 560 does make sense and is the same formula used in the SIMPLE IRA contribution calculator mentioned above.
Strangely enough, the IRS does give a great explanation of why you should use the worksheet in Chapter 5 of publication 560 on the page for Self-Employed Individuals – Calculating Your Own Retirement-Plan Contribution and Deduction.
“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.”
Why they haven’t fixed this error in over 10 years beat me.
If you use the formula in Publication 560 chapter 3 your calculation will reduce your plan compensation more than what’s referenced in the tax code and most other places. That means you’ll contribute less to your retirement based on an IRS error.
It’s unfortunate there is no path the requesting additional guidance or reviewing errors on the IRS website or their Publications.