Figuring Deductible SEP-IRA Contributions

Employees:

Figuring SEP-IRA contributions made on behalf of your employees is straight forward:

  • Multiply the employee's compensation (e.g., gross wages or salary) by the contribution rate stated in the plan.

Special Computation for Self-Employed Persons

Figuring your own deductible contribution is not as straight forward as it is for your employees.

You must determine:

  • Your correct compensation amount to be used in figuring your own deductible contribution and
  • Your correct contribution rate (which is not the same rate stated in the plan that is used for employees; your contribution rate will be lower).

Figuring your deductible contribution is a three-step process:

  • Figure your net earnings from self-employment
  • Figure your reduced contribution rate
  • Figure your maximum deductible contribution

STEP 1:

Figure your net earnings from self-employment.

Net earnings from self-employment equals:

  • Net profit on Schedule C, line 31 (or F) if you're a sole proprietor, reduced by
  • your self-employment tax deduction deducted on Form 1040, line 27).

Note: If you're self-employed, you deduct your own SEP contributions on Form 1040, line 28.

STEP 2:

Figure your reduced contribution rate.

Since your deduction for your own contributions and your net earnings depend on each each other, you determine your deductible contributions indirectly by reducing the rate stated in the plan document.

To figure your reduced rate, you divide the plan rate (the numerator) by 1 plus the plan rate (the denominator).

Assume the plan rate is 10% (.10):

  • 1+.10 equals 1.10 (110.0% - this is the denominator)
  • .10/1.10 = .090909 - This is your contribution rate

STEP 3: Figure your maximum deductible contribution.

  • Multiply your compensation (STEP: 1) by
  • Your reduced contribution rate, .090909 (STEP: 2)

Example:

You're a Schedule C filer.

  • The SEP plan contribution rate is 10%.
  • Schedule C shows a net profit of $80,000.
  • Your deduction for one-half of your self-employment tax (deducted on Form 1040, line 27) is $5,652.

Step 1: Figure your net earnings from self-employment.

Subtract one-half of your self-employment tax liability deducted on Form 1040, line 27 from your Schedule C net profit, line 31.

  • $80,000 minus $5,652 = $74,348.

Net earning from self-employment: $74,348

Step 2: Figure your reduced contribution rate.

Your plan rate is 10%.

Your reduced contribution plan rate is: .090909, figured as follows:

  • 1 + .10 = 1.10 (110.0%)
  • .10/1.10 =.090909

Step 3: Figure your maximum deductible contribution.

Your maximum deductible contribution is: $6,759, figured as follows:

  • $74,348 (STEP 1) x .090909 (STEP 2) = $6,759
  • Your maximum deductible SEP-IRA contribution is $6,759

Where to deduct your SEP-IRA contribution:

  • Deduct your own contribution on Form 1040, line 28 (tax year 2008).
  • Deduct contributions you make on their behalf employees on Schedule C, line 19 (or Schedule F for an unincorporated farming business).

QuickBooks Self-Employed
For Freelancers and independent Contractors

- Organzie your financial data into one central accounting system on the cloud
- Software kept up to date.
- Your data kept secure
- Anytime, anywhere data access.
- Pay your quarterly estimated taxes online.
- Export Schedule C to TurboTax at year-end for faster filing.
- Save up to 50% off QuickBooks Self-Employed. Track every deduction! Start your free trial now!

Have an accounting or bookkeeping question? Email it to me.