A self-employed individual’s compensation for retirement plan purposes is based on his or her earned income. In brief, earned income is net earnings from self-employment (NESE) and can be derived from a sole proprietorship, single member LLC or an entity taxed as a partnership in which the individual’s services are a material income producing factor). A plan then deducts from NESE (1) the IRC §404 deduction for retirement plan contributions for the proprietor, member or partner, and (2) one-half of the self-employment taxes (SE Tax) the individual pays. This process is designed to put unincorporated businesses on an even footing with corporations. Corporations are permitted to deduct the company’s share of social security tax (FICA), which is one-half of the total FICA paid.
For 2011 (and at least the first two months of 2012), the employee portion of FICA tax for wages less than the taxable wage base ($106,800 in 2011 and $110,100 in 2012) is 4.2%. Normally the rate is 6.2% and the 2% reduction applies only to the employee’s portion of FICA. It does not apply to the employer’s portion, which remains at 6.2%. Therefore, the SE Tax rate applicable during this period is 10.4%. Normally the rate is 12.4%, but self-employed individuals receive the benefit of the 2% reduction in FICA taxes that W-2 employees also receive (up to the taxable wage base). This rate applies to the adjusted NESE, up to the taxable wage base (reduced by W-2 wages). Keep in mind there is also a 2.9% Medicare component to the SE Tax which remains unchanged. So, the total SE Tax rate for 2011 is 13.3% of adjusted NESE up to the taxable wage base, plus 2.9% of adjusted NESE over the taxable wage base.
Here is an example:
A self-employed individual has NESE of $155,000 and no wages. In 2010, the individual’s SE Tax was $17,394 and the SE Tax adjustment (one half of the FICA tax calculated on the Form 1040) was $8,697. In 2011, the individual’s SE Tax will be $15,258, due to the change of rates, but the SE Tax adjustment will be $8,695. The SE Tax adjustment is only $2 less than it would have been in the absence of the rate change, even though the individual is saving over $2,100 in SE Tax.
In an effort to bring some measure of tax relief to American workers, Congress reduced the employee’s share of social security tax withholding by 2% of up to the taxable wage base for 2011, and has extended that reduction for at least the first two months of 2012. How exactly does this affect pension contribution calculations for the self-employed? The answer is very little!
