If your business is taxed as a sole proprietorship or partnership, your owners' compensation for 401(k) purposes is based on self-employed income — not a W-2. This article explains what to report to Gusto Retirement, how we calculate adjusted earned income, and what to do in edge cases like losses or high compensation. Expand the sections below to learn more.
Self-employed income is earned income that only applies to entities taxed as a partnership or sole proprietorship — not entities taxed as corporations. If your plan has owner-employees who get earned income, additional calculations and adjustments are required to determine the owner's or partner's compensation for plan purposes.
The Internal Revenue Service (IRS) requires owners earning self-employed income to take specific deductions from self-employment earnings. These deductions determine the owner's compensation for 401(k) plan purposes and for nondiscrimination testing. Gusto calculates these deductions and adjustments.
Note: IRS 401(k) nondiscrimination testing deadlines do not always align with tax reporting deadlines.
For a self-employed sole proprietor or a partner in an entity taxed as a partnership, compensation equals earned income from your company:
Sole proprietors report this amount on Schedule C of your Form 1040 (net profit or loss).
Partners in a partnership report this amount on Line 14a of the Schedule K-1 (Form 1065) of your Form 1040 (self-employment earnings or losses).
Gusto Retirement needs the actual amounts you include on tax filings. We cannot use estimated amounts, as these determine the compensation used in nondiscrimination and limit testing.
Important: If you are a C-corp or S-corp owner, report only your W-2 compensation. Only those wages count as compensation for 401(k) plan purposes. K-1 income for an S-corp owner reported on Form 1120-S cannot be included as 401(k) compensation.
If your compensation exceeds the annual compensation cap, the limit is applied after we determine adjusted earned income. Report your full compensation even if you think it will exceed the cap. This limit is applied after all adjustments have been made.
If you have questions about your individual circumstances, consult your tax advisor. To learn more about compensation in your 401(k) plan, refer to your Summary Plan Description (SPD), located in your Gusto Retirement dashboard under Resource Library in the Your Plan Information folder.
Compliance refund deadlines are based on your plan's automatic contribution arrangement type, regardless of your company's tax filing deadline:
Automatic contribution arrangement (ACA) plans — Mar. 15
Eligible automatic contribution arrangement (EACA) and qualified automatic contribution arrangement (QACA) plans — Jun. 30
If required refunds are not removed from the plan by the deadline, a 10% penalty tax may apply.
Note: Gusto Retirement will not run ADP and ACP tests (if applicable to your plan) until you have provided and confirmed your compensation.
Calculating compensation for owners with earned income is one of the more complex calculations in 401(k) plan administration. The IRS explains this adjustment on its website in a different way, but the results are the same.
For an owner who does not get any employer contributions, follow these steps to calculate compensation:
If ownership is shared, divide the company's applicable profits accordingly. For example, if you own 50% of the company, you earn 50% of the profits. This step is typically already done for each K-1. Skip this step if the company is 100% owned by one owner.
Reduce the profits/gross earned income by the employer contributions made to participants (match, nonelective, profit sharing, or top-heavy minimum contributions). If the plan is owned by a partnership, adjust the employer contributions for each owner's share of expenses. The share of expenses is usually the same as the ownership percentage and is reflected on the "capital" line in Section J of the K-1.
Further reduce profits/gross income by ½ of the self-employment tax. To calculate the self-employment tax, see Schedule SE and other IRS resources.
The result is the owner's compensation, as defined in the plan, used for compliance testing (like ADP/ACP testing).
For an owner who gets employer contributions, there is one additional step. If the contribution depends on compensation (for example, a pro rata contribution that is a percentage of compensation), the compensation used to calculate the percentage (step 5) must be reduced by the contribution (step 4), making the calculation circular.
To follow these steps:
If ownership is shared, divide the applicable profits accordingly. Skip this step if the company is 100% owned by one owner.
Reduce the profits/gross earned income by the employer contributions made to participants (match, nonelective, profit sharing, or top-heavy minimum contributions). If the plan is owned by a partnership, adjust the employer contributions for each owner's share of expenses (reflected on the "capital" line in Section J).
Further reduce profits/gross income by ½ of the self-employment tax.
Additional step: Reduce by the employer contribution made for the owner (for example, 3% of compensation determined at step 5).
The result is the owner's compensation, as defined in the plan, used to calculate contributions (for example, multiply by 3% to determine the contribution at step 4) and for compliance testing.
If an owner earned both self-employment income and W-2 wages, Gusto Retirement needs both amounts to complete compliance testing and contribution calculations. This can happen when:
The entity type changed mid-year, resulting in the owner's wage type changing.
A W-2 employee became a partner during the year.
A partner gave up ownership and became a W-2 employee during the year.
An owner earned a W-2 from an unrelated employer (this affects self-employment taxes in the earned income calculation, but generally does not otherwise affect the contribution calculation).
To report this, email [email protected] with the subject line "Reporting W2 and SEI compensation" and include the following:
Your Account ID for account verification.
Entity type of the company sponsoring the Gusto Retirement plan. For LLCs, include how the LLC will be taxed.
If there were entity type changes or changes to how the entity was taxed mid-year: the time period for each entity type, and which entity type will deduct the employer contributions (or how much each will deduct).
Your self-employment income: from Schedule C (Form 1040), line 31, or from Schedule K-1 (Form 1065) Part III, line 14(a). Note: K-1 (Form 1120-S) is not self-employment income and should not be reported.
W-2 income paid from an unrelated employer (if applicable).
If W-2 income was paid by the employer, list the amount with reason: entity type changing mid-year, or W-2 employee becoming a partner or partner relinquishing partnership mid-year.
Gusto Retirement needs accurate earned income numbers to calculate contribution limits and complete nondiscrimination testing, even if an owner has a loss or high income above the IRS limit.
The annual additions limit caps overall plan contributions to the lesser of:
100% of compensation, or
$72,000 in 2026
If an owner has a loss, any owner's draws made during the year need to be refunded as an excess contribution. The owner will not be eligible for a contribution because 100% of their compensation for plan purposes will be $0.
If an owner has compensation above the annual compensation limit ($360,000 in 2026), report the gross profits or earned income even if it is above this limit. This lets Gusto Retirement calculate compensation and plan contributions correctly.
If you report compensation equal to the cap when it is actually above it, the compensation used for compliance testing and employer contributions will be below the limit. Our calculations will not be accurate, because the reported amount would be further reduced by self-employment deductions and employer contributions made for W-2 employees.