SEP-IRA
From Wikipedia, the free encyclopedia
A Simplified Employee Pension Individual Retirement Account is a variation of the Individual Retirement Account used in the United States. Even more so than the SIMPLE IRA, the SEP-IRA really is "simple." There are no real administration costs if you are self-employed and don't have any employees. If you do have employees, all employees must receive the same benefits under a SEP plan. Since SEP accounts are treated as IRAs, funds can be invested the same way as any other IRA.
For a detailed reading on SEPs, see IRS Pub 560.
Deadline for Establishment and Contributions:
Filing deadline for employer's tax return, including extensions.
The following employees who meet the following conditions:
1) be at least 21 years of age
2) has worked for the employer for at least three of the previous five years, and
3) received at least $450 in compensation for the tax year
must be eligible for the employer's SEP-IRA plan.
SEP-IRA funds are taxed at ordinary income tax rates when qualified withdrawals are taken after age 59.5 (the same rule as for traditional IRAs). Contributions to a SEP plan are deductible: they will lower a taxpayer's income tax liability in the current year.
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[edit] Contribution Limits
SEP-IRA contributions are treated as part of a profit-sharing plan. For employees, the employer may contribute up to 25% of the employee's wages to the employee's SEP-IRA account. For example, if an employee earns $40,000 in wages, the employer could contribute up to $10,000 to the SEP-IRA account because 25% of $40,000 equals $10,000.
The total contribution to a SEP-IRA account is the lesser of 25% of income (20% for self-employed before self-employed tax credit is included; see below) or $42,000 for 2005, $44,000 for 2006; thereafter, the amount is indexed for inflation. Note that contributions may be made to the plan up until the date that the employer's return is due for that year.
[edit] Self-employed
The contribution limit for self-employed persons is more complicated; barring limits, it is 18.587045% (approximately 18.6%) of net profit. The computation is in IRS Pub 560, section 5, Table and Worksheets for the Self-Employed, specifically Deduction Worksheet for Self-Employed.
The two issues are:
- FICA tax
- Reduced rate
[edit] FICA tax
SEP contribution limits are computed, not from net profit, but from net profit adjusted for the deduction for self-employment tax (2006 Form 1040, line 27, from Schedule SE, Section A, line 6, or Section B, line 13). Barring limits, this is half the 15.3% FICA tax, levied on net earnings, which are 92.35% of net profit. Thus adjusted net profit (net profit minus deduction for self-employment tax) is 92.935225% of net profit; note that adjusted net profit is close to but slightly more than net earnings.
[edit] Reduced rate
The limit of 25% applies to wages, not (adjusted) net profit.
In the above example, where an employee earns $40,000 and the employer contributes 25% of that, $10,000, the employee has received $50,000 total, of which 20% goes to the SEP-IRA.
When a business is a sole proprietorship, the employee/owner both pays themselves wages, and makes an SEP contribution, which is limited to 25% of wages, which are profits minus SEP contribution. For a particular contribution rate CR, the reduced rate is CR/(1+CR); for a 25% contribution rate, this yields a 20% reduced rate, as in the above.
[edit] Overall
Thus the overall contribution limit (barring limits) is 20% of 92.935225% (which equals 18.587045%) of net profit.
For example, if a sole proprietor has $50,000 net earnings from self-employment on Schedule C, then the "1/2 of self-employment tax credit", $3,532, shown on adjustments to income at the bottom of form 1040, will be deducted from the net earnings and the result is multiplied by 20% to arrive at the maximum SEP deduction, $9,293.
I don't understand this:
Note that net earnings INCLUDE the proposed deduction for contributions to your own SEP-IRA. In this example, the sole proprietor has therefore $59,293 in net income before his (maximum) SEP-IRA contribution.
[edit] IRS Publications and Forms
- IRS Pub 560 (Retirement Plans for Small Business - SEP, SIMPLE, and Qualified Plans)
- IRS Pub 590 (Individual Retirement Arrangements)
- IRS Form 5305 (SEP Agreement)
