Are SEP IRA Contributions Pre-Tax?

A Simplified Employee Pension, or SEP IRA, is a retirement savings plan designed for self-employed individuals and small business owners. It offers a straightforward way to make substantial, tax-advantaged contributions for both the business owner and any eligible employees. Unlike more complex retirement plans, SEP IRAs are noted for their ease of setup and lower administrative costs, making them an attractive option. This plan structure allows for flexibility, as contributions are not required every year.

Tax Deductibility of Contributions

Contributions made to a SEP IRA are considered pre-tax. For a self-employed individual or a small business owner, these contributions are tax-deductible as a business expense. This action lowers the business’s net taxable income for the year. The deduction is claimed by the business, not the individual who receives the contribution.

When an employer makes a contribution to an employee’s SEP IRA, that amount is not included in the employee’s gross income for the year. This means the employee does not pay immediate income tax on the funds they receive. The money is then able to grow tax-deferred, meaning no taxes are paid on the investment earnings as they accumulate. The combination of an upfront tax deduction for the employer and tax-deferred growth is a primary benefit.

The funds contributed by the employer are immediately 100% vested for the employee, meaning the employee owns the money outright as soon as it is deposited. This is true even if the employee leaves the company shortly after the contribution is made. This immediate ownership is a defining feature of SEP plans.

Contribution Limits and Calculations

The amount that can be contributed to a SEP IRA is governed by annual limits set by the IRS. For 2025, contributions are limited to the lesser of 25% of compensation or $70,000. This dollar limit is indexed for inflation. Only the employer can make contributions to a SEP IRA; employees cannot contribute through payroll deductions.

For a self-employed individual, the calculation is more complex because their “compensation” must first be determined. The calculation starts with the net profit from the business, which is then reduced by one-half of the self-employment taxes paid. This effectively means the contribution rate for a self-employed person is closer to 20% of their net earnings from self-employment, rather than the 25% applicable to employees.

For example, a sole proprietor with $100,000 in net self-employment income must first account for the deduction of one-half of their self-employment tax. Their compensation base for the SEP calculation would be lower, and the maximum contribution is based on this adjusted figure. For 2025, all contributions must be based on compensation that does not exceed $350,000.

Reporting the Deduction on Your Tax Return

A sole proprietor or a partner in a partnership reports the deduction on Schedule 1 of Form 1040, “Additional Income and Adjustments to Income.” This deduction directly reduces their adjusted gross income (AGI).

For incorporated businesses, the deduction is reported on the business’s corporate income tax return. A C corporation would claim the deduction on Form 1120, while an S corporation reports the contributions on Form 1120-S. The deduction reduces the corporation’s net profit, which then flows through to the owners’ personal tax returns in the case of an S corporation.

Taxation of Withdrawals

Since SEP IRA contributions are made with pre-tax dollars and grow tax-deferred, all withdrawals from the account are treated as taxable income. The entire amount withdrawn—both the original contributions and all investment earnings—is taxed at their ordinary income tax rate for that year. This is the same tax treatment applied to withdrawals from a traditional IRA or a 401(k) plan.

Distributions taken before the account holder reaches age 59½ are generally subject to an additional 10% early withdrawal penalty tax. This penalty is applied on top of the regular income tax owed on the distribution. There are some specific exceptions to this penalty, but they are limited. The rules governing withdrawals and penalties are the same as those for traditional IRAs.