What is the contribution limit for self-employed person to their SEP-IRA?

Question

For a few years I've been contributing to a SEP-IRA for myself as the sole employee/employer. Until this year, I have been calculating my max contribution as 25% of my total SE income. I realize that is wrong now, but finding the exact contribution limit has been very confusing. We can ignore the inflation adjusted upper ceiling (50k+) since it's above my percentage limit.

The websites I've seen that mention there being a difference for the employer's own contributions usually say the percentage limit is 20% of net income. My understanding of net income for my simple case (I work from home and don't have significant business-exclusive expenses) is net income = income - 0.5*SEtax, equivalent to 0.925*income.

20% * net income is much less than 0.25 * income, so it's a bit scary to think about correcting my contributions for 2019 and 2020 and taking out the excess with a 6% excise tax (I haven't yet done my contribution for 2021: got an extension).

Fortunately (!) I got a CP2000 notice from the IRS recently because I forgot to include some security trades on my 2020 return[1]. In addition to the security correction, they also corrected my SEP contribution. But they didn't correct it to 20% on net income, they corrected it to 25% on net income. Can I take that as definitive evidence that my limit should be 25% of my net income?

Taking 100k income as an example:

1	2
SE income	100000
½ SE tax	7500
Net income	92500
25% on SE income	25000
20% on SE income	20000
25% on net income	23125
20% on net income	18500

If these had been my numbers, my original return would have the 25000 number and the CP2000 corrected it to 23125.

1. One of the big ones didn't report cost basis, so it looked like a lot of unreported income. Actually though it was a big capital loss for me so the IRS owes me a little more refund even after correcting the SEP deduction. Sorry IRS, no substantial understatement of tax penalty for you (gotta love the irony)!

Answer 1

Sorry to say this, but ... your limit is indeed 20% of net income (profit - half SE tax), not 25%. See the Rate Table for Self-Employed in Pub 560. (Not sure what's going on with the CP2000 you got, but it seems wrong.)

25% is the maximum "plan contribution rate" that the employer can contribute for any given employee. The reason the contribution for the employer themself is 20%, not 25%, is that the calculations for the profit-sharing plan contribution deduction and the SE tax deduction are circular: when you make an employer contribution to your profit-sharing plan, you deduct the contribution from your profit, which reduces your SE tax, which reduces the employer's deductible portion of SE tax, which will increase your net earnings further, which forces you to make another employer contribution to your profit-sharing plan ....

Since it's a circular calculation, the IRS has worked it through for you and figured out that if the employer makes a contribution that's 20% of their Schedule C net income, the employer's contribution comes out to 25% (the maximum plan contribution rate) × (SE profit - employer-deductible portion of SE tax - the employer contribution). See under the Deduction Limit for Self-employed Individuals heading, Pub 560.

In your example with $100k SE profit, your SE tax should have been computed as $100k × 92.35% × (12.4% Social Security + 2.9% Medicare) = $14129.55. Half of this, $7064.78, is the employer deductible portion of SE tax (not sure how you got $7500 in your example). So your net earnings are $100k - $7064.78 = $92935.23. You make an employer contribution of 20% of $92935.25 = $18587.05, and deduct it. Notice that your SE profit, $100k, less your deduction for half SE tax, $7064.78, less your deduction for the employer contribution, $18587.05, comes out to $74348.17; and 25%, your maximum plan contribution rate, of $74348.17 is $18587.04, which is almost exactly the amount of your employer contribution.