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.
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.
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
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.
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.
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.