SEP-IRA Deducton and Contribution Limits
"Your article SEP, SIMPLE, Retirement Plan Contribution Deduction contains the following quote: 'Limits: Your maximum contribution to a SEP-IRA is 20% of your self-employment income or $42,000, whichever is less.' Shouldn't this be 25%? Everything else I've read says 25%. Please clarify."
You can contribute 25% of your wages to a SEP-IRA, if you are an employee participating in your employer's retirement plan.
If you are self-employed, however, you do not have wages. Instead, you have net profits from the business venture. Self-employed people can contribute 20% of your net profits* up to $42,000 (increases to $44,000 for 2006). Now net profits for the SEP-IRA are calculated differently. You take your net self-employment income and subtract one-half of your self-employment taxes. The resulting "net net" self employment income is then multiplied by 20% to get your contribution amount.
This lower 20% rate is well-documented in IRS Publication 560, Retirement Plans for Small Business. See the section on Contribution Limits, and scroll down to "Tax treatment of excess contributions."
J.K. Lasser's Your Income Tax has an excellent chapter on retirement plan options for self-employed people. You will want to read chapter 41 of the JK Lasser book to learn more about SEP and other retirement plans.
Fidelity Investments has an excellent SEP-IRA calculator to determine your maximum contribution. I am in no way recommending you invest through Fidelity. I just like using their calculator.
One final tip. You have until your final deadline, including extensions, to contribute to a SEP-IRA for last year. So if you file an extension, you will have until October 16, 2006, to fund your SEP-IRA for last year. However, you do have to fund the SEP before you file your tax return. If you don't file for an extension, the last day you can contribute to a SEP would be April 17, 2006.
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Comments
Unless I’m missing something, the fidelity SEP calculator is dangerously misleading in terms of either correcting (or not) for being self employed. The maximum contribution is all cases is 25%, it’s just that the calculation is done differently for self employed such that the net result is at most 20% for them and 25% for employees. The problem is that the calculator doesn’t make it clear enough whether it’s taking that into account or not.
Also I don’t think “Net Business Profits” is even nearly clear enough. The calculator needs to prompt like this:
Line X from form XXXX, or line Y from form YYYY, etc.
Thanks for clarifying!
Hi,
If for the first 6 months of the year I worked for someone else and contributed to a 401k and the last 6 months of the year I was self-employeed, are my sep-ira contribution limits restrained by my 401k contributions?
Thanks much