3829 / What rules govern the deduction for contributions by a self-employed individual to a Keogh plan?

The deduction for any employee being paid on a W-2 basis is the same whether to a plan of a corporation or to a Keogh plan. The calculation of deductible contributions for a self-employed individual to a Keogh plan works in a backward way. “Compensation” for all purposes of meeting the IRC’s qualification requirements, as applied to a self-employed individual, is based on earned income after a deduction for one-half self-employment taxes and the self-employed individual’s own contribution. Each self-employed individual will require a separate contribution calculation. The contribution is not reported as an employer contribution on the partnership’s tax return or a sole proprietor’s Schedule C. Each self-employed individual’s contribution to a profit sharing plan can be determined without respect to what the other participants are doing or what the plan requires. This means that it is not possible to know what the self-employed individual’s compensation is for meeting the various IRC limits until after the individual’s contribution is determined. Thus, although a W-2 employee may receive up to 25 percent of compensation as a contribution, the self-employed individual has a 20 percent gross earned income limit. The 20 percent of gross earned income results in a 25 percent of net earned income calculation.¹

In determining his or her adjusted gross income, a self-employed person deducts his or her plan contributions directly from gross income; the deduction is allowable whether or not the person itemizes deductions. A self-employed individual deducts the portion of the contribution made by the business on his or her behalf on his or her own individual return; the contributions are not treated as expenses of the business.²

Contributions on behalf of a self-employed individual may not be used to create or increase a net operating loss.³

Employer contributions allocable to the purchase of life, accident, health, or other insurance on behalf of self-employed persons are not deductible. The cost of such coverage ( Q 3948) is subtracted from the full contribution to determine the amount deductible.⁴

If life insurance protection is provided under a plan, the amount to be subtracted is the Table 2001 (or P.S. 58) cost ( Q 3948) plus the cost of any contract extras, such as a waiver of premium. This produces a result for self-employed individuals similar to the result for employees – the value of the life insurance protection and contract extras is taxable. If amounts attributable to deductible employee contributions are used to purchase life insurance, the amount to be subtracted is the amount so used.