Today, the Simplified Employee Pension (SEP) plan is a popular retirement savings option for self-employed sole proprietors and partners. However, before you open a SEP, it’s important to understand the distinction between contributions made under a SEP for employees and contributions that benefit the self-employed sole proprietor or partner.
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When making SEP contributions for employees, the employer must base contributions on an employee’s compensation (as reported on a W-2 form). However, if you’re a self-employed sole proprietor or partner, the SEP contribution is based on your earned income. Earned income is generally defined as net earnings from self-employment in a trade or business in which the personal services of the taxpayer produce income.
For tax purposes, net earnings for a self-employed sole proprietor are gross income less business deductions as shown on the Schedule C tax form. Net earnings for a partner, however, include the partner’s distributive share of partnership income or loss (other than that from separately treated items such as capital gains or losses). According to IRS Publication 560, “Guaranteed payments to limited partners are net earnings from self-employment if they are paid for services to or for the partnership.” But distributions of other income or losses to a limited partner are not considered net earnings.
For 2015, the Internal Revenue Code (IRC) limits SEP employer contributions to the lesser of 25% of compensation or $53,000 (subject to inflation indexing). The maximum amount of compensation eligible for consideration for qualified plans is $265,000. Contributions may grow on a tax-deferred basis. As with other qualified retirement plans, distributions taken before the age of 59½ may be subject to a 10% Federal income tax penalty.
Additional rules apply to a self-employed sole proprietor or partner when the maximum allowable contribution to a SEP is calculated. Because a self-employed person’s compensation is his or her net earnings from self-employment, the net earnings of that person must be adjusted by reducing the plan’s contribution rate. For self-employed individuals who are not considered employees of their own corporations, the limits result in an allowance of only 20% of self-employment compensation.
In addition to the limits on contribution amounts, the IRC places a limit on the deductibility of employer contributions. Employers can deduct contributions to a SEP of up to 25% of participants’ compensation in a particular calendar year. When the taxpayer is a self-employed sole proprietor or partner, that person must report the deduction directly on his or her return for the appropriate tax year (the deduction for employees is claimed on a sole proprietor’s Schedule C, and tax deductions for the sole proprietor’s contribution are claimed on IRS Form 1040).
Self-employed sole proprietors and partners are in a unique situation with SEPs as both employer and employee. So, it’s possible to reap the tax benefits of making a potentially substantial contribution to a retirement plan on your own behalf. However, you need to stay informed of the contribution limitations set forth under the IRC.