Earned vs. Passive Income: Calculating Retirement Contribution Limits
How much can I contribute to a retirement plan? That question comes up for us regularly. Most people think that the question is primarily a function of how much money they earn. But that is a more complex calculation than simply looking at an income statement. Only one type of income can be used as the basis for a retirement plan contribution. Whether you are contributing to a 401k, defined benefit plan, or pension plan, the IRS treats earned and passive income differently. It is a common misconception that retirement plan contributions can be based on total income (that is, earned income plus passive income). Retirement plan contribution calculations, however, can only be based on earned income, that is, income that is subject to FICA and Medicare taxes.
What is Earned Income
Earned income is: wages or salaries you receive for performing services. This would include any earnings from W-2 wages, to self-employment income, to commissions and bonuses.
What is Passive Income
Passive income is: money generated from sources other than your active efforts. This could include rental income, interest and dividend income, capital gains, or business income from a passthrough entity such as an LLC or S Corporation.
Contributions to retirement plans are based solely on earned income. This rule was put in effect because retirement plan income from your 401(k) or other plan is intended to provide an income in retirement that is commensurate with your earnings during the years in which you are actively working. The assumption is that, passive income will continue to provide income past retirement age and therefore the pension, DB plan or 401k income will be in addition to that passive income.
The active vs passive income delineation is more complex when it comes to K1 income.
Some K1s only report passive income. But others are subject to self-employment earnings as denoted in box 14 and are therefore considered earned income that can be used as part of the contribution limit calculation.
What is a K1
A K1, for anyone who doesn’t know, is a document that reports the income, deductions, and credits of a partnership to its partners. The K1 is used to report the items on each partner’s individual tax return. The K1 is an important document for partnerships because it helps ensure that each partner pays the correct amount of taxes on their share of the partnership’s income and tracks how much money was distributed to each partner during the year.
There are many factors to consider when planning for retirement and deciding how much to save annually. contribution limits can be complex calculations and your advisor can help ensure you are maximizing your ability to save for retirement base don all factors allowable. Check out our calculator for a general idea of what you annual contribution limit might be based on your age.