401(k) Earned Income – What You Need to Know

Owners of a partnership or sole proprietorship (or an LLC taxed as either) are considered “self-employed individuals” for 401(k) plan purposes. 401(k) plans must allocate and test the annual contributions made to self-employed individuals using a special definition of plan compensation called earned income. When applicable, earned income is calculated by the plan’s Third-Party Administrator (TPA) based on information prepared by the employer’s Certified Public Accountant (CPA). The CPA, in turn, will use the TPA's calculation to finalize the employer’s year-end tax returns. 

When 401(k) TPAs and CPAs do not coordinate this back-and forth properly, frustrating delays in the completion of their year-end work is often the result. Here’s what employers need to know to best ensure their earned income calculation goes smoothly.

The Earned Income Calculation

Earned income is considered a “circular” calculation because its ultimate amount depends upon the contributions allocated to plan participants. The earned income of sole proprietors and partners is calculated differently. 

Sole proprietors - the starting point is an IRS Form 1040, Schedule C, Line 31 amount that has not yet been reduced by plan contributions. That amount is then reduced by the following items:

  • Plan contributions (both employee and employer) allocated to common-law employees.
  • 50% of the self-employment tax deduction under Code Section 164(f).
  • Employer contributions allocated to the sole proprietor. 
    • If elective deferrals are excluded from plan compensation (rare), these contributions must also reduce the sole proprietor’s earned income.

Partners - the starting point is a Schedule K-1 (Form 1065), Line 14(a) amount that has not yet been reduced by plan contributions. That amount is then reduced by the following items:

  • The partner’s share of plan contributions (both employee and employer) allocated to common-law employees.
  • The deduction claimed for Section 179 expenses, the deduction claimed for unreimbursed partnership expenses, and the depletion claimed on oil and gas properties.
  • 50% of the self-employment tax deduction under Code Section 164(f). 
  • Employer contributions allocated to the partner. 
    • If elective deferrals are excluded from plan compensation (rare), these contributions must also reduce the partner’s earned income.

In short, the earned income calculation is complicated. Below is an example assuming a 10% profit sharing contribution. Plan compensation includes elective deferrals in the example.

Step

Description

Amount

Starting Point

Schedule K-1 (Form 1065), Line 14(a) amount + partner’s share of plan contributions

$250,000.00 

Deduction for Section 179 expenses

($2,000.00)

Common Law Employee Contributions

The partner’s share of plan contributions allocated to common-law employees.

($30,000.00)

IRC 164(f) Deduction

(Steps 1 + 2 + 3) * .9235 (to reflect 1402(a)(12) deduction)

$201,323.00 

Self-employment taxes

$22,913.17 

IRC 164(f) deduction (Step 5 * 50%)

($11,456.58)

Owner Contributions and Earned Income

Steps 1 + 2 + 3 + 6

$206,543.42 

Elective Deferrals

$26,000.00 

Profit Sharing Contribution

$18,772.00 

10 

Earned Income (Step 7 - 9)

$187,771.42 

The Back-and-Forth Necessary to Properly Calculate Earned Income

401(k) TPAs and CPAs must coordinate to properly calculate earned income. The necessary back-and-forth process involves the following steps:

  • The TPA receives the applicable starting point information from the CPA. 
    • Earned income cannot be calculated without it. 
    • It may take months following the close of the year for a CPA to make this information available.
  • The TPA calculates earned income during the year-end nondiscrimination testing process.
  • The CPA finalizes the employer’s year-end tax returns based on the TPA’s calculation.

How to Best Ensure a Smooth Calculation Process

When the earned income calculation process breaks down, the reason is most often a disagreement between the 401(k) TPA and CPA about the calculation’s starting point.

To best ensure a smooth calculation, I recommend CPAs provide a “draft” Schedule C or K-1 with the applicable amount not yet reduced by plan contributions. In other words, not provide a final Schedule C or K-1 amount the 401(k) TPA must manually gross-up to complete plan testing using industry software. 

Earned Income Frustration Can Be Easy to Avoid!

Every year, I see earned income calculations needlessly delay the completion of year-end plan testing and employer tax returns. In most cases, the root cause is the same - the 401(k) TPA and CPA have not coordinated the back-and-forth process necessary for each to complete their respective work timely.

This confusion is easy to avoid. The key is understanding starting point information a 401(k) TPA needs to calculate earned income while plan testing.