In “Which Retirement Account Should I Fund?” we wrote this about Simplified Employee Pension Plan (SEP) IRA contributions:

SEP contribution limits for 2015 are the lesser of 25% of the employee’s income or $53,000. There are no catch-up provisions. This contribution can be in addition to what you contribute to your 401k or 403b through your employer.

Contributions to your 401k or 403b are considered employee contributions and are limited in 2015 to $18,000 plus a $6,000 catch-up across all of your jobs. But SEP contributions are considered employer contributions and are limited on a per plan basis not a per person basis.

If you are already maxing your employer plan this is a way to shelter about 25% of your extra business income up to $53,000 for each separate business entity. It isn’t 25% because it is after all the self-employment taxes. The actual percentage is about 18.6%.

The calculations for this are a little strange. Conceptually, the employer side of the self-employment tax has to be paid before you calculate the percentage you can contribute. This step accounts for lines (b) and (g) in the calculation and the accuracy check.

The amount contributed to the SEP is considered to be contributed by the employer and therefore does not count in the calculation of the maximum percentage. In other words, your maximum contribution percentage is based on how much you contribute divided by your post-contribution salary. In algebra, that looks like this:

p = X / (S – X), where P is your maximum contribution percentage, S is your salary after deducting the employer half of the self-employment tax, and X is the amount you contribute.

When the percentage is 25%, you get:

0.25 = X / (S – X)

Solving for X, you get:

X = (0.25 / 1.25) S = 0.20 S

20% is the reduced plan contribution rate in line (d) of Example #1.

When the percentage is 10% as in Example #2, you would calculate the reduced plan contribution this way:

X = (0.10 / 1.10) S = 0.0909 S, which is line (d) in Example #2.

Here is the math explaining how to compute how much you can contribute with $100,000 of income or profit when you are trying to contribute the maximum 25%:

## Example #1 |
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(a) | $100,000.00 | Income or Schedule C profit | ||||

(b) | minus | $7,065.00 | (1/2 the self employment tax of 14.130%) | |||

(c) | equals | $92,935.00 | Income reduced by 1/2 self-employment tax | |||

(d) | times | 0.20 | Reduced plan contribution rate | |||

(e) | equals | $18,587.00 | Allowed contribution and deduction | |||

How to verify the accuracy of this calculation: |
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(f) | $100,000.00 | Income or Schedule C profit | ||||

(g) | minus | $7,065.00 | (1/2 the self employment tax of 14.130%) | |||

(h) | minus | $18,587.00 | Allowed contribution and deduction | |||

(i) | equals | $74,348.00 | Amount subject to plan’s full rate | |||

(j) | times | 0.25 | Plan’s full 25% rate | |||

(k) | equals | $18,587.00 | Allowed contribution and deduction |

As you can see, the actual maximum percentage turns out to be close to 18.6%.

Here is another example when you are only contributing a nominal 10%:

## Example #2 |
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(a) | $100,000.00 | Income or Schedule C profit | ||||

(b) | minus | $7,065.00 | (1/2 the self employment tax of 14.130%) | |||

(c) | equals | $92,935.00 | Income reduced by 1/2 self-employment tax | |||

(d) | times | 0.0909 | Reduced plan contribution rate | |||

(e) | equals | $8,448.63 | Allowed contribution and deduction | |||

How to verify the accuracy of this calculation: |
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(f) | $100,000.00 | Income or Schedule C profit | ||||

(g) | minus | $7,065.00 | (1/2 the self employment tax of 14.130%) | |||

(h) | minus | $8,448.63 | Allowed contribution and deduction | |||

(i) | equals | $84,486.37 | Amount subject to plan’s full rate | |||

(j) | times | 0.10 | Plan’s 10% rate | |||

(k) | equals | $8,448.63 | Allowed contribution and deduction |

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