How are SEP IRA Contribution Limits Determined?

Angela Johnson
Angela Johnson
Businessman with a briefcase
Businessman with a briefcase

There are two methods for calculating SEP IRA contribution limits. The SEP IRA is set up to allow self employed individuals and business owners to benefit from a retirement plan. It allows contributions of up to 20% of net income for the self employed, or 25% of W-2 wages. The type of salary a self employed individual or business owner may receive from his or her company will determine the amount of allowable contribution that can be made to a SEP IRA.

Contributions to a SEP IRA are generally tax deductible, and the interest that is earned on the SEP IRA grows tax deferred. This allows self employed individuals or business owners to have a retirement plan with relatively high contribution limits, unlike traditional IRAs where the contribution limits are much lower. The SEP IRA contributions are tax deductible for the employer who contributes to the retirement fund.

An employer or self employed individual may decide to contribute any amount within 0-20% of net income if the business is incorporated, or up to 25% if the business is unincorporated. Each employee has his or her own individual account, and the employer funds each of these accounts according to the contribution percentage chosen each year. The employer's contribution to the SEP IRA must match the employee's contribution.

SEP IRA contribution limits allow the employer or self employed business person to give generously to their own fund as well that of their employees. Employees benefit by receiving tax free money funded by the employer. This tends to entice and retain strong employees, thus promoting company loyalty and low turnover rates.

Contributions to SEP IRAs are optional from year to year, so if a company's profits fall below a certain threshold, the employer may opt not to contribute that year. On the other hand, if the company's profits exceed the goal for the year, the employer may contribute that year as an added benefit and incentive to the employees. The SEP IRA is flexible in that it allows employers to skip contributions on certain years, and then resume contributions during times of financial gain.

Funds may be withdrawn from a SEP IRA when a person reaches 59 1/2 years old, and funds are required to be withdrawn by the age of 70 1/2 years old. If funds are withdrawn before a person is 59 1/2 years old, the withdrawn funds may be subject to an additional 10% penalty tax unless they are used for medical or educational expenses.

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