Understanding SEP IRA Deduction Rules

If you’re self-employed, one type of account that you can use to save for your retirement is a simplified employee pension (SEP) individual retirement account (IRA). Here’s what you need to know about the SEP IRA, including the rules regarding contributions and deductions.

SEP IRA Explained

The SEP IRA is a retirement savings account specifically for individuals who are self-employed or own small businesses. To open a SEP IRA, you must have freelance income or one employee. Note that the employees are not able to make contributions to their SEP plans. Only the employer or business owner can make contributions to SEP plans on their behalf, as stated by CNN Money.

Rules Regarding Deductions for the SEP IRA

A benefit of using the SEP IRA to save for your retirement is that you can deduct your contributions to reduce your business or your own taxable income. How much of your contributions you can deduct depends on whether you make the contributions as a employer or as an individual.

When you make the contributions as an employer, you can deduct all your contributions, or 25 percent of each employee’s compensation, whichever number is less, as stated by the IRS. For example, assume that you have two employees. One makes $40,000 and the other makes $45,000. You deposit 20 percent of each employee’s salary into a SEP plan for a total contribution of $17,000. Since this figure is less than 25 percent of their compensation ($21,250), you can deduct all your contributions.

If you’re making contributions to a SEP as an individual, you need to use the IRS’s Rate Table for Self-Employed, or the Rate Worksheet for Self-Employed to determine your permissible contribution rate. Your contribution rate will depend on your plan’s contribution rate. Then, you need to use this info in the Deduction Worksheet for Self-Employed to calculate your maximum deduction.

Contribution Limits to the SEP IRA

The SEP IRA does have contribution limits, and the rules for these differ from the maximum allowed deductions. These limits are the same whether the plan is for your employees or you. You can contribute up to the lesser of 25 percent of your employee’s or your own compensation, or $56,000 (for the 2019 tax year).

If you’re making contributions on your own behalf, you have to calculate your compensation by taking into account your deductible self-employment tax, your contribution rate and your retirement plan contribution. You will use the Table and Worksheets for the Self-Employed to calculate your maximum contribution.

Contribution Guidelines

For most SEP IRAs, when you’re making contributions on behalf of your employees, you must contribute the same percentage for each employee. For example, if employee A makes $20,000 and employee B makes $30,000 and you’re contributing 10 percent of each employee’s salary, employee A will receive a contribution of $2,000, while employee B will receive a contribution of $3,000.

Other Info About the SEP IRA

As an employer or individual, you don’t have to make annual contributions to a SEP IRA. It’s fine to skip years if necessary, and make contributions as a bonus rather than a regular benefit.

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There are also salary limitations for your employees that limit your contributions. As of the 2019 tax year, the maximum income for a SEP IRA is $280,000. This means that if an employee’s salary exceeds this amount, you can only make a contribution on the allowed amount. Assume that an employee makes $300,000 and you plan to contribute 10 percent of each employee’s salary. In this case, you can only contribute 10 percent of $280,000, not $300,000.

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