A Simplified Employee Pension, or SEP-IRA, can be a great way for business owners and self-employed individuals to provide tax-advantaged retirement benefits for themselves and their employees. While the 2015 SEP retirement contribution limits are pretty straightforward for employers' contributions, the limits for self-employed individuals aren't quite as easy to understand. Here's a rundown of what you need to know about SEP contributions and how to figure out your own if you're self-employed.
The limits are rather generous
One of the most compelling reasons to use a SEP is for its generous contribution limits. Employers are allowed to contribute as much as 25% of each employee's compensation or $53,000 for 2015, whichever is less. To make this even better,100% of SEP contributions come from the employer, so the SEP limits don't affect an employee's ability to contribute to a traditional or Roth IRA on their own behalf.
There is no such thing as "catch up" contributions for older employees as there are with 401(k) and IRA accounts, and there is no "vesting" process -- employees are 100% vested in their account funds at all times. In a nutshell, since all of these characteristics are straightforward, the process is "simplified" -- hence the name "Simplified Employee Pension."
Calculating SEP contributions for self-employed individuals
While the SEP limits are straightforward and simplified, it is a little more complicated for self-employed individuals to figure out how much they can contribute to their own account. Based on the previous discussion of SEP contribution limits, it might seem that a business owner or sole proprietor who earns a net profit of $100,000 in 2015 could contribute as much as 25% of that amount to their own SEP, or $25,000.
However, this is not the case for a couple of reasons -- specifically, the self-employment tax and the SEP contribution itself. Since retirement contributions and half of the self-employment tax don't count toward self-employment income for the purpose of calculating eligibility, this must be accounted for when determining how much you can contribute.
In mathematical form, the self-employment SEP contribution limit is determined by the following calculation.
As you can see, the maximum contribution for a self-employed individual who earns $100,000 is $17,171, not $25,000 as the published limits might suggest. This is important to know if you plan to contribute the maximum allowable amount, as excess contributions left in the plan after the due date for their tax return could be subject to a 16% excise tax (6% for employees + 10% for employers).
Just a few notes:
- To calculate your SEP contributions if you don't want to contribute the full 25% maximum, simply substitute that percentage in the calculations above. For example, to determine a 10% contribution rate, substitute 1.10 on the fourth line and 0.10 for the contribution percentage.
- If your adjusted net profit (the third line of the calculation above) is greater than $265,000, the maximum you can contribute to your SEP is $53,000.
- The self-employment tax rate for 2015 is 15.3% (12.4% for Social Security on the first $118,500 in income and 2.9% on all income for Medicare). However, to determine the amount of your income that is subject to self-employment tax, multiply the total by 92.35% to adjust for the portion of the tax normally paid by an employer.
The bottom line
If you're self-employed, the amount you can contribute to your employees' SEP accounts is easy to figure out, but your own contribution is more complicated than it may appear. Make sure you use the proper calculations to max out your contributions without going over the limit in order to ensure that your SEP provides you with years of simplified retirement investing.