How Much Will a SEP IRA Reduce My Taxes?

A Simplified Employee Pension (SEP) IRA offers a retirement savings solution for self-employed individuals and small business owners. Employers contribute to their own retirement and to eligible employees’ accounts. Contributions made to a SEP IRA are tax-deductible, reducing taxable income in the year they are made. The SEP IRA aims to provide a straightforward and flexible retirement plan with higher contribution limits compared to traditional or Roth IRAs, making it an attractive option for those seeking to save substantial amounts for retirement while also benefiting from immediate tax deductions.

Who Can Contribute and Basic Rules

Individuals who are self-employed, including freelancers and gig workers, or small business owners (sole proprietors, partnerships, or corporations), are eligible to establish and contribute to a SEP IRA. This plan suits businesses with few or no employees due to its specific contribution rules. If a business has employees, the employer must contribute to the SEP IRA of all eligible employees.

An employee is generally considered eligible if they are at least 21 years old, have worked for the employer in at least three of the past five years, and have received a minimum amount of compensation. Employers can set less restrictive eligibility requirements but cannot make them more stringent than the IRS guidelines. Contributions must be made by the employer, not the employee, and they must be a uniform percentage of compensation for all eligible participants. The deadline for making SEP IRA contributions for a given tax year is typically the employer’s tax filing deadline, including any extensions.

Determining Your Deductible Contribution

Calculating the maximum deductible contribution to a SEP IRA involves specific steps, especially for self-employed individuals. The contribution limit is the lesser of 25% of an employee’s compensation or a set dollar maximum ($69,000 for 2024 and $70,000 for 2025). For self-employed individuals, the calculation is based on “net earnings from self-employment” (gross income minus business expenses). This amount must then be reduced by one-half of the self-employment tax and by the SEP IRA contribution itself, creating a circular calculation.

Because the contribution amount depends on a figure that is derived after subtracting the contribution, the IRS provides specific guidance, including worksheets and rate tables in Publication 560, to help resolve this. For practical purposes, the 25% employer contribution rate effectively translates to a maximum of 20% of a self-employed individual’s net earnings from self-employment after accounting for the deduction of one-half of self-employment taxes. The maximum compensation that can be considered for this calculation is also capped, at $345,000 for 2024 and $350,000 for 2025.

How SEP IRA Contributions Reduce Your Taxes

Contributions to a SEP IRA directly reduce an individual’s taxable income. These contributions are considered “above-the-line” deductions, reducing your Adjusted Gross Income (AGI). A lower AGI directly leads to lower taxable income and a reduced tax bill. This reduction applies whether you itemize deductions or take the standard deduction.

For self-employed individuals, the deduction for SEP IRA contributions is reported on Schedule 1 of Form 1040, specifically on the line for self-employed SEP, SIMPLE, and qualified plans. This placement on Schedule 1 ensures the deduction impacts AGI. A reduced AGI can also expand eligibility for certain tax credits or other deductions that are dependent on AGI thresholds. Thus, contributing to a SEP IRA helps save for retirement while lowering your income subject to federal tax.