Why your solo 401(k) employer contribution is 20% of net earnings, not 25%

Every provider says 25%. Publication 560 hands you a table that says 20%. Both are right, and the reason is circular.

ExactSplit · Updated April 28, 2026

Two numbers that both look right

Open the account documents for any solo 401(k) and you will find the same sentence. The employer contribution is limited to 25 percent of compensation. Then you go to work out what that means for you, find the worksheet in IRS Publication 560, and it hands you a rate table that says 20 percent. Nobody explains why the two differ, and a lot of people assume one of them must be a mistake.

Neither is a mistake. The 25 percent figure is the statutory limit under section 404 for a qualified plan. The 20 percent figure is what 25 percent works out to once you account for how compensation is defined for someone who is self-employed. They are the same rule, expressed against two different bases.

Compensation is not your profit

For an employee, compensation is simple. It is the wages on the W-2. The employer contributes 25 percent of that and the calculation is done.

For a sole proprietor there is no W-2. Your compensation for plan purposes is your net earnings from self-employment, reduced by two things. The first is the deductible half of your self-employment tax. The second is the contribution to the plan itself.

Read that second reduction again, because it is the whole story. The contribution reduces the compensation that the contribution is calculated from. The number you are trying to find appears on both sides of the equation. That is a circular definition, and it is why the simple 25 percent cannot be applied directly.

Solving the circle

Write it out with C for the contribution, NE for net earnings from self-employment, and H for the deductible half of SE tax. The rule says C equals 0.25 times the quantity NE minus H minus C.

Move the C terms to one side. C plus 0.25 C equals 0.25 times the quantity NE minus H. That gives 1.25 C equals 0.25 times the quantity NE minus H, so C equals 0.25 divided by 1.25, times the quantity NE minus H. And 0.25 divided by 1.25 is exactly 0.20.

So the maximum employer contribution is 20 percent of net earnings after the half SE tax deduction. That is not an approximation and it is not a rule of thumb. It is the closed form solution to the circular definition, and it is exactly where the 20 percent in the Publication 560 rate table comes from. The table simply does this division for you at every plan percentage from 1 to 25.

A worked example

Take a sole proprietor with 100,000 dollars of net profit on Schedule C. Self-employment tax is calculated on 92.35 percent of that, which is 92,350 dollars. At 15.3 percent, SE tax is 14,129.55 dollars. The deductible half is 7,064.78 dollars.

Net earnings after the half SE tax deduction are 100,000 minus 7,064.78, which is 92,935.22 dollars. Twenty percent of that is 18,587.04 dollars. That is the maximum employer contribution.

Now check it against the original rule. Plan compensation is net earnings less half SE tax less the contribution, so 92,935.22 minus 18,587.04, which is 74,348.18 dollars. Twenty five percent of 74,348.18 is 18,587.04. The contribution is exactly 25 percent of the compensation that remains after the contribution is taken out. The circle closes.

The mistake that actually costs money

The common error is to take 20 percent of gross net profit, skipping the half SE tax step. On 100,000 dollars that gives 20,000 dollars. The real ceiling is 18,587 dollars. The difference is 1,413 dollars of excess contribution.

Excess contributions are not a rounding error you can ignore. They are subject to a 10 percent excise tax under section 4972 for every year they remain in the plan, and they have to be withdrawn or carried forward against a future year's limit. Getting this wrong in a good year and not noticing until you file is exactly how a routine retirement contribution turns into a correction with penalties attached.

The other direction is less dangerous but still costly. People who are nervous about the circular calculation sometimes contribute well under the limit to be safe, leaving thousands of dollars of deductible room unused. The calculation is not hard once you know the formula. There is no reason to leave money on the table out of caution.

The two caps that sit on top

The 20 percent figure is the contribution rate limit. Two dollar caps also apply, and for higher earners they bind before the rate does.

The first is the compensation limit under section 401(a)(17). Only the first 360,000 dollars of compensation counts for 2026, per Notice 2025-67. Above that, the contribution is 25 percent of 360,000 regardless of how much more you earned.

The second is the annual additions limit under section 415(c), which is 72,000 dollars for 2026, up from 70,000 in 2025. That is the ceiling on everything going into the account in a year from both the employee and employer sides combined, not counting catch-up contributions, which sit on top under section 414(v)(3).

For most one-person businesses at moderate income, the 20 percent rate is the binding constraint and the dollar caps are far away. Above roughly 400,000 dollars of net earnings the 415(c) cap takes over.

The employee side is a separate limit

A solo 401(k) has two sides, and this post has only covered one of them. The employer contribution is the 20 percent figure. The employee elective deferral is a separate limit under section 402(g), 24,500 dollars for 2026, and it is not reduced by the circular calculation because it is not a percentage of anything. You can defer up to the limit or up to 100 percent of your compensation, whichever is less.

If you are 50 or older, a catch-up of 8,000 dollars applies for 2026. If you turn 60, 61, 62, or 63 during the year, the SECURE 2.0 higher catch-up of 11,250 dollars applies instead. Both figures are from Notice 2025-67.

So on 100,000 dollars of net profit, a solo proprietor under 50 could put in 24,500 dollars as a deferral plus 18,587 dollars as an employer contribution, for 43,087 dollars total. That is the number that makes the solo 401(k) so much more powerful than a SEP-IRA at this income level, since a SEP has no deferral side at all.

How ExactSplit handles it

ExactSplit solves the circular calculation in closed form, applies the 401(a)(17) compensation cap and the 415(c) annual additions cap on top, and shows you the room remaining in each account separately. It then runs the whole tax calculation again with a contribution added and reports the actual saving, rather than multiplying by your bracket, because retirement contributions also reduce your qualified business income and part of the saving is clawed back through section 199A.

Every limit in the engine carries the notice it came from. If you want to check the numbers, the citations are in the code and on the screen.