How to Calculate SEP IRA Contributions for Employers and Self-Employed

A Simplified Employee Pension (SEP) IRA allows employers and self-employed individuals to contribute to retirement savings with tax advantages and flexibility. However, calculating contributions requires understanding IRS limits and income considerations to ensure compliance and maximize benefits.

Contribution Limits

The IRS sets annual contribution limits, adjusted periodically for inflation. In 2024, the maximum contribution per employee is the lesser of 25% of compensation or $69,000. This applies to all eligible employees, including business owners.

SEP IRAs are funded solely by employer contributions. The percentage contributed must be the same for all eligible employees. If a business owner contributes 10% of their compensation, they must contribute 10% for each employee.

For self-employed individuals, contributions are based on net earnings after deducting business expenses and the employer’s share of self-employment taxes. This results in a lower contribution amount compared to traditional employees.

Determining Compensation for Calculation

For employees, compensation includes wages, salaries, commissions, and bonuses. Noncash benefits such as health insurance or expense reimbursements do not count. Employers must use W-2 earnings for calculations.

For business owners and self-employed individuals, contributions are based on net earnings after business expenses but before SEP IRA contributions. They must also deduct half of their self-employment tax, reducing the earnings eligible for contributions.

The IRS provides an adjusted percentage for self-employed individuals. Since contributions reduce net earnings, the effective limit is 20%. For example, if net earnings are $100,000 after expenses and self-employment tax adjustments, the maximum contribution is $20,000.

Steps to Determine Employer Contribution

Employers must select a contribution percentage and apply it consistently to all eligible employees. After determining each employee’s eligible compensation, they apply the chosen percentage, ensuring contributions do not exceed the lesser of the percentage-based cap or the maximum dollar limit.

Contributions must be funded directly by the business, not deducted from employees’ wages. Employers should maintain records of the contribution percentage, total compensation, and calculations for compliance. Contributions must be deposited into SEP IRA accounts by the business’s tax filing deadline, including extensions, to qualify for tax deductions.

Steps for Self-Employed Individuals

Self-employed individuals start by determining net profit from business operations, reported on Schedule C (Form 1040) or the applicable tax form for partnerships and LLCs. After deducting business expenses, net income is further reduced by the deductible portion of self-employment tax, calculated on Schedule SE.

Once adjusted net earnings are established, the contribution limit is calculated using the 20% rate. For example, if adjusted net earnings are $80,000, the maximum SEP IRA contribution is $16,000.

Handling Excess Contributions

Exceeding SEP IRA limits results in tax penalties. The IRS imposes a 10% excise tax on excess amounts remaining in the account beyond the tax filing deadline, applied annually until corrected.

To fix an overcontribution, the excess and any earnings must be withdrawn before the tax filing deadline. If not removed, the excess may be taxed twice—once when contributed and again when withdrawn in retirement. Employers can also reclassify the excess as a contribution for the following tax year, provided it stays within that year’s limits. Proper documentation ensures compliance with IRS regulations.