Earned vs. Passive Income: How It Affects Your Retirement Contributions
When planning for retirement, one of the biggest questions business owners ask is: How much can I contribute to my retirement plan? While it might seem like a simple question based on total earnings, the IRS sets strict rules about what type of income qualifies for retirement contributions. The key distinction? Only earned income counts.
What is Earned Income?
Earned income is money you make from actively working. It includes:
- W-2 wages or salaries
- Self-employment income
- Commissions and bonuses
This income is subject to FICA and Medicare taxes, which is why the IRS allows it to be used as the basis for retirement plan contributions. Whether you’re contributing to a 401(k), Defined Benefit Plan, or pension plan, your contribution limits are based only on this type of income.
What is Passive Income?
Passive income is money that comes from investments or business activities that don’t require your direct involvement. Examples include:
- Rental income
- Interest and dividend income
- Capital gains
- Business income from an LLC or S-Corp (in some cases)
Because passive income isn’t tied to active work, it does not count when calculating retirement contributions. The IRS assumes that passive income sources, like rental properties or investments, will continue generating income in retirement, making additional tax-advantaged contributions unnecessary.
The K-1 Complexity
If you’re a business owner receiving income through a K-1, the distinction between earned and passive income can be more complicated.
A K-1 reports partnership income, deductions, and credits for tax purposes. While many K-1s only report passive income, others may include self-employment income—which is considered earned income and can be used to calculate retirement contributions. Look at Box 14 of your K-1 to see if it includes self-employment earnings. If it does, that portion of your income may qualify.
Why This Matters for Your Retirement Plan
Understanding the difference between earned and passive income is essential when designing a retirement strategy that maximizes tax-advantaged savings. Many business owners assume they can contribute based on total income, but only earned income applies.
Contribution limits can be complex, and every situation is different. Working with an advisor can help ensure you’re maximizing your ability to save for retirement based on all allowable income sources.
Want a quick estimate of how much you can contribute? Check out our calculator to see what your annual contribution limit might be based on your income and age.
