SEP IRA Limitations
By Jason Watson, CPA
Posted February 28, 2020
If you earned $100,000 in your garden-variety LLC, your SEP IRA deduction is $18,587. How do we get there?
| Net Business Income | 100,000 | ||
| Reduction for Biz Portion of SE Tax | 7,650 | (100,000 x 7.65%) | |
| Self-Employment Income | 92,350 | ||
| SE Tax at 15.3% | 14,130 | (92,350 x 15.3%) | |
| Deduction for Half of SE Tax | 7,065 | ||
| Net Business Income | 100,000 | ||
| Deduction for Half of SE Tax | 7,065 | ||
| Income Base for SEP IRA Calcs | 92,935 | ||
| 20% SEP IRA Contribution | 18,587 |
It is a two-step process. First, we need to calculate the deduction for half of the self-employment tax ($7,065). Second, we take the net business income and subtract half of the SE tax. This difference ($92,935) is then multiplied by 20%.
The 7,065 number should mean something. If you recall in a previous chapter, the self-employment tax rate is 15.3% but the effective rate is 14.13%. This is because of the reduction of the business income subject to the SE tax by the “employer” portion of SE tax. 7,065 x 2 is 14,130 or 14.13%. In other words, if you made $100,000 you would pay $14,130 in self-employment taxes.
Therefore the SEP IRA calculation in our example is reduced to $100,000 x (1- half of 14.13%) x 20% = $18,587. Or simply $100,000 x 0.9294 x 20%.
Wow, did we belabor the heck out of that? Admit it; you’re better for it… you can wow your friends at the next cocktail party… or… proudly announce on Jeopardy, “I’ll take self-employment retirement calculations for $200 please Alex.”
Back to the issue at hand; if you elect S corporation taxation, your SEP IRA is now 25% of your W-2. Let’s say you paid yourself $40,000 in wages, your SEP IRA contribution would be $10,000 versus $18,587.
However, if you leveraged a solo 401k plan instead, your total contribution is now $19,500 (for the 2020 tax year) plus 25% of your W-2 or $29,500. Another way to look at the SEP IRA versus 401k calculation is 401k = SEP IRA + $19,500 + $6,500 (if 50 or older).
The reduction in what you can save in your SEP IRA or solo 401k cannot be viewed in isolation. In the $100,000 example above, your S Corp savings might exceed $9,000. Also recall that tax deferrals are merely little IOU’s to the IRS. As such, the small reduction in contribution limits and the small tax deferrals and even smaller ultimate tax savings (provided your retirement marginal tax rate is less than your current tax rate) are shadowed by the savings of an S corporation.
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| Additional Payroll Taxes | Trapped S Corp Assets |
Jason Watson, CPA, is the Managing Partner of WCG, Inc., a progressive Colorado Springs tax and consultation firm.
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