SEP IRA Limitations

By Jason Watson, CPA
Posted Sunday, December 29, 2024

If you earned $100,000 in your garden-variety LLC, your SEP IRA deduction is $18,587. How do we get there?

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 (SE) 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 Aaron.” We certainly miss you, Alex. Sorry, Aaron, not many miss you.

Do you want another way to calculate self-employment taxes? Business income x 92.35% x 15.3%. The 92.35 is simply the inverse of 7.65 which is half of the self-employment tax rate.

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. That is a huge difference!

However, if you leveraged a solo 401k plan instead, your total contribution is now $23,500 (for the 2025 tax year) plus 25% of your W-2 or $33,500. Another way to look at the SEP IRA versus 401k calculation is 401k = SEP IRA + $23,500+ $7,500 (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.

Sidebar: While WCG CPAs & Advisors defers to your financial planner, we usually recommend Roth (post-tax) deferrals into your solo 401k plan. Yes, pay taxes now, but then your growth and distributions are tax-free later in life. Tax savings is a lifelong perspective. Also, keep in mind that the discretionary employer (your business) contribution are usually pre-tax. Therefore, you are achieving some immediate tax savings and hedging your tax bets at the same time. If you are going to have a tax bill, would you prefer it today during your working years or when you are watching Matlock reruns? More about this in our retirement chapter.

Note To The Sidebar: The SECURE Act of 2022 allowed for employer contributions to be post-tax (Roth). Many 401k plans are outdated and don’t allow for this, and need to be restated.