Self-Employed Retirement Contributions: Why It's 20%, Not 25% (and How to Calculate Yours)

The short answer: 25% is the headline; 20% is what you actually get

If a retirement plan document says “contribute 25% of compensation,” a W-2 employee’s employer simply writes a check equal to 25% of the employee’s salary. The math is direct. But for a self-employed taxpayer — a sole proprietor filing Schedule C — “compensation” has a definition that creates a loop: it is net earnings from self-employment after the retirement contribution deduction itself. That loop is what turns 25% into 20%.

The IRS Rate Worksheet in Publication 560 resolves the loop with a single step: divide the plan rate by one plus the plan rate. At a 25% plan rate:

25% ÷ (1 + 25%) = 25% ÷ 125% = 0.2000 — exactly 20%

This guide shows where that formula comes from, derives it algebraically, and walks through a full line-by-line example at $100,000 in Schedule C profit using the IRS Publication 560 Deduction Worksheet and Rate Worksheet format.

Step 1 — What “compensation” means for the self-employed

For a self-employed taxpayer, “compensation” for retirement plan purposes is not a line on a pay stub. It is net earnings from self-employment, defined as Schedule C net profit minus the deduction for one-half of self-employment (SE) tax. Two sub-steps build that figure.

Net SE earnings and the 92.35% factor

IRS Schedule SE directs taxpayers to multiply Schedule C net profit by 92.35% to determine net SE earnings — the income base on which SE tax is calculated. The 92.35% factor equals 1 minus 7.65% (half of the 15.3% SE tax rate). It reflects the fact that a self-employed person bears both the employee and employer halves of FICA. The “employer half” (7.65%) is treated as a cost embedded in gross income and is excluded from the SE tax base, exactly as employers deduct their share of payroll taxes before computing tax on wages. (Above the Social Security wage base, the SS portion of the SE tax drops out and only the 2.9% Medicare rate applies; Schedule SE carries the two-rate calculation for that case.)

The half-SE-tax deduction

After SE tax is computed, the taxpayer may deduct one-half of it as an above-the-line deduction on IRS Schedule 1, Line 15 (also called out in the Deduction Worksheet in Publication 560). This deduction mirrors the deduction a conventional employer receives for the employer’s share of FICA — self-employed taxpayers get the economic equivalent. It reduces adjusted gross income, not Schedule C net profit, so it does not reduce the SE tax base itself.

The compensation formula (IRS Publication 560 Deduction Worksheet)

Net SE earnings = Schedule C profit × 92.35% (Schedule SE)
SE tax = Net SE earnings × 15.3% (below SS wage base; Schedule SE)
Half SE tax = SE tax ÷ 2 (Schedule 1, Line 15)
Compensation = Schedule C profit − Half SE tax (IRS Pub 560 Deduction Worksheet)

Step 2 — Why 25% collapses to 20%: the circular definition

For a W-2 employee, the employer contributes 25% of wages. Wages exist independently of the contribution, so the arithmetic is one-step. For a sole proprietor, the plan document uses the same language — “contribute 25% of participant’s compensation” — but “compensation” is now a moving target. Under IRS rules, the retirement contribution is itself an above-the-line deduction. That deduction reduces net income. And the IRS defines “compensation” for sole proprietors as net earnings after that deduction. The definition references the result it is trying to produce.

Let C be the contribution and E be net earnings before the contribution deduction (i.e., Schedule C profit minus half SE tax, from Step 1):

C = 25% × (E − C) [plan definition: 25% of net earnings after contribution]
C = 0.25E − 0.25C
C + 0.25C = 0.25E
1.25C = 0.25E
C = 0.25E ÷ 1.25
C = 0.20 × E [the 20% effective rate]

More generally, for any plan contribution rate r:

Effective self-employed rate = r ÷ (1 + r)

This is the IRS Rate Worksheet formula in Publication 560. At r = 25% (the maximum SEP-IRA employer contribution rate): 0.25 ÷ 1.25 = 0.2000 exactly. At lower plan rates the collapse is proportionally smaller — at 15%, the effective rate is 15/115 ≈ 13.04% — but 25% is the figure that appears most often in plan documents and in the IRS’s own examples (IRS “Self-employed individuals: Calculating your own retirement plan contribution and deduction”).

A fully worked example: $100,000 Schedule C profit

The following uses the step structure of the IRS Publication 560 Deduction Worksheet and Rate Worksheet, with every line labeled to its source.

Schedule C net profit: $100,000.00

Step 1 — Net SE earnings (Schedule SE, Line 3):
  $100,000 × 92.35% = $92,350.00

Step 2 — SE tax (Schedule SE, Line 4):
  $92,350 × 15.3% = $14,129.55
  (Assumption: all earnings below Social Security wage base.)

Step 3 — Half SE tax deduction (Schedule 1, Line 15; IRS Pub 560 Deduction Worksheet):
  $14,129.55 ÷ 2 = $7,064.78

Step 4 — Compensation / net earnings (IRS Pub 560 Deduction Worksheet):
  $100,000 − $7,064.78 = $92,935.22

Step 5 — Employer contribution at 20% (IRS Pub 560 Rate Worksheet):
  $92,935.22 × 20% = $18,587.04

Verification: $18,587.04 should equal 25% of ($92,935.22 − $18,587.04) = 25% of $74,348.18 = $18,587.05. The one-cent gap is a rounding artifact; the identity holds. Dollar-cap check: $18,587.04 is well below the 2026 §415(c) limit of $72,000.

The $18,587.04 figure is the maximum SEP-IRA contribution or the employer-side maximum for a Solo 401(k) at this income level. It is also the figure that should appear on IRS Form 1040, Schedule 1, Line 16 (self-employed SEP, SIMPLE, and qualified plans deduction), assuming no other retirement plan deductions apply.

The exception: S-corp owner-employees and the real 25% of W-2 wages

An S-corporation is a separate legal entity. When a business owner pays themselves W-2 wages through their S-corp, those wages are “compensation” in the ordinary sense — established before any retirement contribution is made. There is no circular definition, and no 20% adjustment is needed.

The S-corp (acting as the employer) may contribute up to 25% of the owner-employee’s W-2 wages as the employer’s profit-sharing contribution. At $80,000 in W-2 wages, the employer contribution is exactly $80,000 × 25% = $20,000. The arithmetic is straightforward.

The payroll tax picture also differs. W-2 wages are subject to FICA (12.4% Social Security + 2.9% Medicare, split between employer and employee). S-corp distributions — profit paid out beyond reasonable W-2 wages — escape FICA, though the IRS requires that the owner-employee receive “reasonable compensation” as wages before taking distributions (IRS Publication 560, S Corporation section). The retirement contribution is calculated on W-2 wages, not on distributions.

The practical implication: the same gross business profit can yield a different allowable retirement contribution depending on entity structure. A sole proprietor with $100,000 net profit can contribute up to $18,587. An S-corp owner who pays themselves $80,000 in W-2 wages from the same profit can direct the corporation to contribute $20,000. The numbers diverge because the definitions of “compensation” diverge. Neither structure is universally better — the comparison involves payroll taxes, administrative costs, and overall tax treatment, not just the contribution ceiling.

Solo 401(k) vs. SEP-IRA at the same profit — and the 2026 dollar caps

Both a SEP-IRA and a Solo 401(k) use the same 20%-of-net-earnings employer formula. The difference is what each plan allows beyond the employer side.

SEP-IRA allows employer contributions only. The maximum is 20% of net earnings (the 25%/(1+25%) rate applied to Schedule C profit minus half SE tax), capped at $72,000 for 2026 under IRC §415(c) (IRS retirement-plan COLA/limits). No employee elective deferrals. No annual filing requirement until plan assets exceed $250,000 (at which point Form 5500-EZ applies). Administratively straightforward.

Solo 401(k) adds an employee elective deferral on top of the same employer contribution. For 2026, the elective deferral limit is $24,500 under IRC §402(g) (IRS retirement-plan COLA/limits). Taxpayers age 50 and older may contribute an additional $8,000 catch-up, for a total employee deferral of $32,500. The combined employer plus employee contribution cannot exceed $72,000 under §415(c) ($80,000 for age-50+ participants when the catch-up is included). The compensation base used to compute the employer side is capped at $360,000 under IRC §401(a)(17) — applying 20% to $360,000 produces exactly $72,000, so the §401(a)(17) cap and the §415(c) cap bind at the same point.

Side-by-side at $100,000 Schedule C profit

Net earnings (from worked example above): $92,935
Employer contribution — both plans (20% × $92,935): $18,587

SEP-IRA total: $18,587

Solo 401(k):
  Employer (profit-sharing): $18,587
  Employee (elective deferral, §402(g) limit): $24,500
  Total: $43,087

The $24,500 gap in this example reflects the employee deferral available only in the Solo 401(k). That advantage narrows as profit rises.

Where the two plans converge

At net earnings of approximately $237,500, the employer piece alone reaches $47,500 (20% × $237,500). The remaining space before the §415(c) cap of $72,000 is exactly $24,500 — the full employee deferral. Above net earnings of $360,000, the employer contribution alone reaches $72,000 (20% × $360,000 = $72,000), consuming the entire §415(c) ceiling. No employee deferral room remains.

At those income levels, SEP-IRA and Solo 401(k) produce the same maximum dollar contribution. The Solo 401(k)’s advantage is concentrated at lower net earnings — typically below $237,500 in net SE earnings — where the employee elective deferral adds meaningful extra tax-advantaged capacity that a SEP-IRA cannot match.

Solo 401(k) plans require an annual filing (Form 5500-EZ or Form 5500-SF) once plan assets exceed $250,000, and must be established by December 31 of the year for which you want to make contributions. SEP-IRA contributions can be made up to the tax-filing deadline (including extensions) and can be opened at the time of contribution. These operational differences matter alongside the dollar limits.

How to run your own number

The inputs that change the result — Schedule C net profit, whether earnings fall below or above the Social Security wage base, plan type, age — make each person’s figure individual. The IRS Publication 560 Deduction Worksheet and Rate Worksheet handle all the steps above, but require working through each line manually.

The WealthExact Self-Employed Retirement Contribution Calculator runs the same IRS worksheet arithmetic — net SE earnings, SE tax, half-SE-tax deduction, the 20% rate conversion, and both SEP-IRA and Solo 401(k) scenarios against the 2026 §415(c) and §402(g) caps — with every line labeled to its source, so you can follow each step or spot-check the result against your own worksheet.

Sources: IRS Publication 560 (2026) — Rate Worksheet and Deduction Worksheet for Self-Employed · IRS “Self-employed individuals: Calculating your own retirement plan contribution and deduction” · IRS Schedule SE (Form 1040) and instructions (net SE earnings, 92.35% factor, SE tax) · IRC §415(c) ($72,000 overall limit, 2026) · IRC §402(g) ($24,500 elective deferral, 2026) · IRC §401(a)(17) ($360,000 compensation cap, 2026) · IRS retirement-plan COLA/limits page

This guide is for informational and educational purposes only. It is not financial, tax, or legal advice. Tax rules are complex, fact-specific, and subject to change. Consult a qualified tax or financial professional before making IRA contribution or conversion decisions.

Last reviewed: June 2026 · Against IRS Publication 560 (for 2026 tax year).