For retirement plan administrators, calculating earned income for self-employed individuals in defined benefit (DB) plans is one of the most nuanced and error-prone tasks. Between tax structures, contribution limits, and compliance testing, it's easy to get lost in the complexity.
Fortunately, there are proven strategies—and powerful tools like ftwilliam.com—that can help you simplify the process, improve accuracy, and stay compliant.
1. Start with the right tax classification
The first step in any earned income calculation is understanding the business structure:
- Corporations report income on form W-2
- Sole proprietors report income on Schedule C
- Partnerships use Schedule K-1
- LLCs may elect to be taxed as sole proprietorships, partnerships or corporations
This classification determines whether you're working with self-employment income or W-2 wages. Self-employment income requires the earned income calculation for plan purposes.
ftwilliam.com Tip: The software prompts you to tag participants as "self-employed," automatically triggering the correct calculation logic based on entity type.
2. Use a reasonable method to allocate contributions
In DB plans, contributions to non-owners reduce business income (and thus self-employment tax), while owner contributions do not. This makes it essential to allocate contributions between owners and non-owners using a reasonable and consistent method. Common approaches include:
- Prorating based on funding targets
- Allocating based on principal credits or account balances
Example: If a plan has $100,000 in contributions and the owner's funding liability is 90% of the total, allocate $90,000 to the owner and $10,000 to employees.
ftwilliam.com Tip: The DB compliance module handles these allocations automatically, based on IRC 404 funding costs.
3. Avoid circular compensation formulas
Defining principal credits as a percentage of compensation can create a circular loop—where compensation depends on the contribution, which in turn depends on compensation. Instead:
- Use flat dollar amounts for principal credits
- Apply a 100% of plan compensation limit, where plan compensation is defined pre-owner deductions, to stay within IRS deduction limits.
Example: Rather than setting a principal credit at 50% of earned income, define it as $100,000 with a cap at 100% of plan compensation.
ftwilliam.com Tip: You can define plan compensation to include deductible contributions under IRC 401(c)(2)(A)(v), stabilizing the calculation and avoiding circular logic.
4. Split contributions across tax years when needed
Self-employed individuals can't deduct more than their earned income. If a contribution exceeds that limit, it can be split across two tax years to maximize deductibility.
Example: If earned income is $92,935 but the DB minimum contribution is $150,000, deduct $92,935 in the current year and the remainder in the next—assuming sufficient income.
ftwilliam.com Tip: The system supports counting contributions in different years for IRC 430 and 404 purposes, thereby allowing split deduction strategies.
5. Use historical compensation to support testing
Low current-year income can cause testing failures, especially in DB/DC combo plans. In these cases, use the high three-year average compensation to support:
- Non-discrimination testing
- Coverage testing
Additionally, historical compensation can be used for higher IRC 415 distribution limits.
Example: An owner with only $5,000 in current-year income but a historical average of $150,000 can use the average for testing.
ftwilliam.com Tip: The software allows you to input and apply historical compensation data for accurate testing and compliance.
6. Automate the entire process with ftwilliam.com
Manual calculations are time-consuming and error-prone. ftwilliam.com offers a comprehensive suite of tools to automate earned income calculations and compliance tasks:
✓ Defined Benefit Compliance Software
- Handles DB and DC contributions
- Automates circular earned income calculations
- Adjusts compensation for testing and allocations
✓ Defined Contribution Compliance Software
- Calculates earned income from Schedule C or K-1
- Applies results across all compliance tasks
- Includes a dedicated self-employment calculation grid
✓ Self-Employment Calculation Grids
- Show original and adjusted compensation
- Provide full transparency into each step of the calculation
Award-Winning Support
ftwilliam.com's customer support team is known for its responsiveness and expertise. Whether you're troubleshooting a complex scenario or setting up a new plan, help is just a call or message away.
Final Thoughts
Defined benefit earned income calculations don’t have to be a source of stress. By applying these strategies and leveraging ftwilliam.com’s powerful tools, plan administrators can ensure accuracy, compliance, and peace of mind.
