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.

**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.

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

**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.

**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.

**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.