SEP Plans for the Self-Employed

If you run your own business, a simplified employee pension (SEP) plan is a great way to save for your retirement, especially if you don't have anybody else working for you. Under the SEP rules, a self-employed person is considered an employee for purposes of plan participation. With no other employees to consider, a self-employed person can set a high contribution percentage and make elective deferrals to potentially help save a maximum of $46,000 on a tax-deferred basis in 2008 ($45,000 in 2007; $44,000 in 2006). Without such a plan, the same self-employed person could only save a measly $5,000 to a traditional IRA in 2008 ($4,000 in 2006 and 2007).

Tip A SEP is the simplest, least expensive, and most efficient way for a small business to establish a qualified plan.

The catch (and there always seems to be one) is that special rules apply for the self-employed person when figuring the maximum deduction for the contributions. For determining the limit on contributions, a self-employed person's compensation is the net earnings from self-employment.

Net earnings are the gross income from your business minus allowable business deductions. Allowable deductions include contributions to employees' (if you have any) and your own SEP-IRAs. You also take into account the deduction for one-half of your self-employment tax.

Planning Tools To help determine the contribution and deduction limit for a self-employed person, use this Contributions and Deductions Table and Worksheets for the Self-Employed.

Because the deduction amount and the net earnings are each dependent on the other, the adjustments that must be made present a "chicken versus egg," which-came-first, type of problem. To solve this problem when figuring your maximum deduction, an adjustment to net earnings is made indirectly by reducing the contribution rate called for in the plan. The reduced rate only applies to the self-employed business owner, and not to the contribution rate for any of the business owner's common-law employees.

Example Solomon (Sol) E. Mio is a 40 year-old self-employed sole proprietor with no employees. Under Sol's SEP plan, he contributes 25 percent of his compensation to his SEP-IRA. His net profit from line 31, Schedule C (Form 1040), is $205,000 in 2006. After filling out Schedule SE (Form 1040), Sol's deduction for self-employment tax is $8,194.90. Sol's self-employed rate and maximum deduction for employer contributions on behalf of himself are as follows: Self-Employed Person's Rate Worksheet 1. Sol's contribution rate as a decimal 0.25 2. Rate in line 1 plus 1 1.25 3. Self-employed rate as a decimal (line 1 divided by line 2) 0.20 Self-Employed Person's Deduction Worksheet 1. Sol's net earnings $205,000 2. Sol's deduction for self-employment tax $8,194.90 3. Subtract line 2 from line 1 $196,805.10 4. Sol's self-employed rate from the first worksheet 0.20 5. Multiply line 3 by line 4 $39,361.02 6. Multiply $220,000 (2006 compensation limit) by plan rate of 20% $44,000 7. Sol's maximum deductible SEP contribution for 2006 (the smaller of line 5 or 6) $39,361.02 To reach the allowed $44,000 total contribution limit for the year, Sol would have to make a small elective contribution of $4,638.98 for 2006.