Where To Deduct Contributions
Deduct contributions you make for your common-law employees on your tax return. For example, sole proprietors deduct them on Schedule C (Form 1040) or Schedule F (Form 1040), partnerships deduct them on Form 1065, and corporations deduct them on Form 1120, Form 1120-A, or Form 1120S.
Sole proprietors and partners deduct contributions for themselves on line 31 of Form 1040. (If you are a partner, contributions for yourself are shown on the Schedule K-1 (Form 1065) you receive from the partnership).
Tax Treatment of Contributions
You can deduct your contributions and your employees can exclude these contributions from their gross income. SIMPLE IRA contributions are not subject to federal income tax withholding. However, salary reduction contributions are subject to social security, Medicare, and federal unemployment (FUTA) taxes. Matching and nonelective contributions are not subject to these taxes.
Reporting on Form W-2. Do not include SIMPLE IRA contributions in the Wages, tips, other compensation box of Form W-2. However, salary reduction contributions must be included in the boxes for social security wages and Medicare wages. Also include the proper code in Box 12. For more information, see the instructions for Forms W-2 and W-3.
Distributions (Withdrawals)
Distributions from a SIMPLE IRA are subject to IRA rules and generally are includible in income for the year received. Tax-free rollovers can be made from one SIMPLE IRA into another SIMPLE IRA. A rollover from a SIMPLE IRA to a non-SIMPLE IRA can be made tax free only after a 2-year participation in the SIMPLE IRA plan.
Early withdrawals generally are subject to a 10% additional tax. However, the additional tax is increased to 25% if funds are withdrawn within 2 years of beginning participation.
More information. See Publication 590 for information about IRA rules, including those on the tax treatment of distributions, rollovers, required distributions, and income tax withholding.
More Information on SIMPLE IRA Plans
If you need more help to set up and maintain a SIMPLE IRA plan, see the following IRS notice and revenue procedure.
Notice 98-4. This notice contains questions and answers about the implementation and operation of SIMPLE IRA plans, including the election and notice requirements for these plans. Notice 98-4 is in Cumulative Bulletin 1998-1.
Revenue Procedure 97-29. This revenue procedure provides guidance to drafters of prototype SIMPLE IRAs on obtaining opinion letters. Revenue Procedure 97-29 is in Cumulative Bulletin 1997-1.
Qualified Plan
A qualified retirement plan is a written plan you can set up for the exclusive benefit of your employees and their beneficiaries. It is sometimes called a Keogh or H.R. 10 plan.
You, or you and your employees, can make contributions to the plan. If your plan meets the qualification requirements, you generally can deduct your contributions to the plan. For more information, see Publication 560.
Your employees generally are not taxed on your contributions or increases in the plan's assets until they are distributed. However, certain loans made from qualified plans are treated as taxable distributions. For more information, see Publication 575.
Qualification requirements. To be a qualified plan, the plan must meet many requirements. They include requirements that determine the following.
- Who must be covered by the plan.
- How contributions to the plan are to be invested.
- How contributions to the plan and benefits under the plan are to be determined.
- How much of an employee's interest in the plan must be guaranteed (vested).
For more information, see Publication 560.
More than one job. If you are self-employed and also work for someone else, you can participate in retirement plans for both jobs. Generally, your participation in a retirement plan for one job does not affect your participation in a plan for the other job. However, if you have an IRA, you may not be allowed to deduct part or all of your IRA contributions. See Publication 590.
Kinds of Qualified Plans
There are two basic kinds of qualified retirement plans: defined contribution plans and defined benefit plans.
Defined Contribution Plan
This plan provides for a separate account for each person covered by the plan. Benefits are based only on amounts contributed to or allocated to each account.
There are two types of defined contribution plans: profit-sharing and money purchase pension.
Profit-sharing plan. This plan lets your employees or their beneficiaries share in the profits of your business. The plan must have a definite formula for allocating the contribution among the participating employees and for distributing the accumulated funds in the plan.
Money purchase pension plan. Under this plan, contributions are fixed and are not based on your business profits. For example, if the plan requires contributions of 10% of each participating employee's compensation, regardless of whether you have a profit, the plan is a money purchase pension plan.
Defined Benefit Plan
This is any plan that is not a defined contribution plan. In general, contributions to a qualified defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants. Your contributions to the plan are based on actuarial assumptions. Generally, you will need continuing professional help to administer a defined benefit plan.
Setting Up a Plan
You must adopt a written plan. The plan can be an IRS-approved master or prototype plan offered by a sponsoring organization. Or it can be an individually designed plan.
Master or prototype plans. The following sponsoring organizations generally can provide IRS-approved master or prototype plans.
- Trade or professional organizations.
- Banks (including savings and loan associations and federally insured credit unions).
- Insurance companies.
- Mutual funds.
Adoption of a master or prototype plan does not mean your plan is automatically qualified. It still must meet all the qualification requirements stated in the law.
Individually designed plan. If you prefer, you can set up an individually designed plan to meet specific needs. Although advance IRS approval is not required, you can apply for approval by paying a fee and requesting a determination letter. You may need professional help with this. Revenue Procedure 2002-6 in Internal Revenue Bulletin 2002-1 may help you decide whether to apply for approval.
Deduction Limits
The deduction limit for contributions to a qualified plan depends on the kind of plan you have.
In figuring the deduction for contributions to these plans, you cannot take into account any contributions or benefits that are more than the limits discussed under Limits on Contributions and Benefits in Publication 560. However, for plan years beginning in 2002 and later years, your deduction can be as much as the plan's unfunded current liability.
Defined contribution plans. The deduction for contributions to a defined contribution plan (profit sharing plan or money purchase pension plan) cannot be more than 25% of the compensation paid (or accrued) during the year to the eligible employees participating in the plan. You must reduce this limit in figuring the deduction for contributions you make for your own account. See Deduction of contributions for yourself, later.
When figuring the deduction limit, the following rules apply.
- Elective deferrals (discussed in Publication 560) are not subject to the limit.
- Compensation includes elective deferrals.
- The maximum compensation that can be taken into account for each employee is $200,000.
Defined benefit plans. An actuary must figure the deduction for contributions to a defined benefit plan because it is based on actuarial assumptions and computations.
Deduction of contributions for yourself. To take a deduction for contributions you make to a plan for yourself, you must have net earnings from the trade or business for which the plan was set up.
Limit on deduction. If the qualified plan is a profit-sharing plan, your deduction for yourself is limited to the lesser of $40,000 or 20% (25% reduced as discussed later) of your net earnings.
Net earnings. Your net earnings must be from self-employment in a trade or business in which your personal services are a material income-producing factor. Your net earnings do not include items excluded from income (or deductions related to that income), other than foreign earned income and foreign housing cost amounts.
Your net earnings are your business gross income minus the allowable business deductions from that business. Allowable business deductions include contributions to SEP and qualified plans for common-law employees and the deduction for one-half your self-employment tax.
Net earnings include a partner's distributive share of partnership income or loss (other than separately stated items such as capital gains and losses) and any guaranteed payments. If you are a limited partner, net earnings include only guaranteed payments for services rendered to or for the partnership. For more information, see Partnership Income or Loss under Figuring Earnings Subject to Self-Employment Tax in Publication 533.
Net earnings do not include income passed through to shareholders of S corporations.
Adjustments. You must reduce your net earnings by the deduction for one-half your self-employment tax. Also, net earnings must be reduced by the deduction for contributions you make for yourself. This reduction is made indirectly, as explained next.
Net earnings reduced by adjusting contribution rate. You must reduce net earnings by your deduction for contributions for yourself. The deduction and the net earnings depend on each other. You make the adjustment indirectly by reducing the contribution rate called for in the plan and using the reduced rate to figure your maximum deduction for contributions for yourself.
Annual compensation limit. You generally cannot take into account more than $200,000 of your compensation in figuring your contribution to a defined contribution plan.
Figuring Your Deduction
Use the following worksheet to find the reduced contribution rate for yourself. Make no reduction to the contribution rate for any common-law employees.
Worksheet 3-A. Rate Worksheet for Self-Employed
| 1) |
Plan contribution rate as a decimal (for example, 10½% = .105) |
|
| 2) |
Rate in line 1 plus 1 (for example, .105 + 1 = 1.105) |
|
| 3) |
Self-employed rate as a decimal rounded to at least 3 decimal places (line 1 ÷ line 2) |
|
After you have figured your self-employed rate, you can figure your maximum deduction for contributions for yourself by completing Worksheet 3-B.
An Example of how to complete the worksheets follows.
Worksheet 3-B. Deduction Worksheet for Self-Employed
| Step 1 |
| Enter your net profit from
line 31, Schedule C (Form 1040); line 3, Schedule C-EZ
(Form 1040); line 36, Schedule F (Form 1040); or line
15a*, Schedule K-1 (Form 1065) |
|
| *General partners should reduce this amount by the same additional expenses subtracted from line 15a to determine the amount on line 1 or 2 of Schedule SE |
| Step 2 |
| Enter your deduction for self-employment tax from line 29, Form 1040 |
|
| Step 3 |
| Net earnings from self-employment. Subtract step 2 from step 1 |
|
| Step 4 |
| Enter your rate from the Worksheet
3-A |
|
| Step 5 |
| Multiply step 3 by step 4 |
|
| Step 6 |
| Multiply $200,000 by your
plan contribution rate (not the reduced rate) |
|
| Step 7 |
| Enter the smaller of step 5 or step 6 |
|
| Step 8 |
| Contribution dollar limit |
$40,000 |
| ·If you made any elective deferrals, go to step 9. |
| ·Otherwise, skip steps 9 through 18 and enter the smaller of step 7 or step 8 on step 19. |
| Step 9 |
| Enter your allowable elective deferrals made during 2002. Do not enter more than $11,000 |
|
| Step 10 |
| Subtract step 9 from step
8 |
|
| Step 11 |
| Subtract step 9 from step 3 |
|
| Step 12 |
| Enter one-half of step 11 |
|
| Step 13 |
| Enter the smallest
of step 7, 10, or 12 |
|
| Step 14 |
| Subtract step 13 from step
3 |
|
| Step 15 |
| Enter the smaller of step 9 or step 14 |
|
| · If you made catch-up contributions, go to step 16. |
| · Otherwise, skip steps 16 through 18 and go to step 19. |
| Step 16 |
| Subtract step 15 from step
14 |
|
| Step 17 |
| Enter your catch-up contributions,
if any. Do not enter more than $1,000 |
|
| Step 18 |
| Enter the smaller of
step 16 or step 17 |
|
| Step 19 |
| Add steps 13, 15, and 18.
This is your maximum deductible contribution |
|
| Next: Enter your deduction
on line 31, Form 1040. |
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