Looking to reduce your taxable income this year? Maxing out a SEP IRA could give you one of the highest tax deductions possible this year.
Your taxable income can get reduced by up to $69,000 in 2024 and $70,000 in 2025 by maxing out contributions to your SEP IRA.
Are you self-employed or run a business with no employees? You may be eligible for a Solo 401k, which has even more tax benefits than a SEP IRA and takes just a few clicks to set up. Learn more in our free Solo 401k Handbook.
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How taxes get reduced through retirement plan contributions
Some retirement plans come in two different options: A traditional account and a Roth account. For example, you may already know about the Traditional IRA and Roth IRA.
- In a traditional retirement account, you contribute with pre-tax dollars that you haven’t paid income taxes on yet. Instead, the amount you contribute to your plan gets deducted from your taxable income for the year. However, your withdrawals in retirement are taxed as regular income.
- A Roth retirement account does not give you any tax deductions. You contribute with money that you’ve already paid income taxes on, but your withdrawals in retirement are tax-free.
A SEP IRA does not have a Roth option and contributions can only be made as pre-tax.
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SEP IRA contributions are tax deductible
When you contribute to SEP IRA, your contributions get deducted from your taxable income for the year. For example, if you made $50,000 this year, and want to contribute $20,000 to your SEP IRA, your new taxable income is now $30,0000 rather than $50,000.
The SEP IRA has a higher contribution limit than other retirement plans like the Traditional IRA or a 401k.
- An IRA only gives you a contribution limit of $7,000 ($8,000 if age 50+) for 2024 and $7,000 ($8,000 if age 50+) for 2025.
- If you’re an employee at a company and have a corporate 401k plan, your contribution limit is $23,000 ($30,500 if age 50+) for 2024 and $23,500 ($31,000 if age 50+) for 2025.
- A SEP IRA has a contribution limit of $69,000 for 2024 and $70,000 for 2025. Business owners can contribute up to 25% of their compensation up to the yearly contribution limit.
If you max out your SEP IRA, you can reduce your taxable income for the year by $69,000 for 2024 and $70,000 for 2025. A SEP IRA does not have a Roth option. You can only contribute to the plan with pre-tax dollars, the same way you would contribute in pre-tax dollars to a Traditional IRA or a 401k.
Equal percentage contributions
If you have any employees, you cannot contribute to your SEP IRA without making equal percentage contributions for your employees. For example, if you contribute 25% of your compensation into your SEP IRA, you’re obligated to contribute 25% of every eligible employee’s compensation into their SEP IRAs. All contributions you make to your employees’ accounts are also tax deductible.
An eligible employee is any individual who is at least 21 years old, worked for your business at least 3 out of the last 5 years, and earned at least $750 in 2024 and $750 in 2025.
What if I’m an employee?
Employees are not allowed to contribute to a SEP IRA and can only receive contributions made by their employer. Therefore, employees who receive SEP IRA contributions from their employer cannot use the SEP IRA to reduce their taxable income. Instead, they could make contributions into a Traditional IRA, even if the contribution limits may be lower. If they have a side hustle with no employees, they could also open a Solo 401k which would open up possible tax deductions up to $69,000 for 2024 and $70,000 for 2025.
How much do I need to make in order to max out my SEP IRA contributions?
SEP IRA contributions are calculated by using 25% of your compensation, with a maximum limit of $61,000 for 2022 and $66,000 for 2023.
Let’s go through the calculations to see how much income you’ll need to make in order to make the largest possible contribution for each year.
- For 2024, the contribution limit is $69,000. Therefore, to max out your SEP IRA, you would roughly need to make around $345,000 pre-tax (25% of $345,000 equals $69,000).
- For 2025, the contribution limit is $70,000. Therefore, to max out your SEP IRA, you would roughly need to make around $350,000 pre-tax (25% of $350,000 equals $70,000).
How to report SEP IRA tax deductions
Contributions made to your SEP IRA must be reported to the IRS by filing IRS Form 5498 before the federal tax filing deadline, which is normally April 15 each year. For reporting 2022 contributions, you have until April 18 since the 15th is a Saturday and the following Monday is a national holiday.
You can also request a 6 month extension if you need more time. If you fail to file your contribution before the deadline, your contributions will be deducted from the following year’s tax returns.
When can I take money out of my SEP IRA?
You can start to take distributions from a SEP IRA without penalties when you reach the age of 59½. Early withdrawals are subject to a 10% penalty plus income taxes.
You’re not obligated to make withdrawals until you reach the age of 73, which is when the required minimum distributions (RMD) kick in. Once you turn 73, you’ll have to take distributions each year until your account is emptied.
Are withdrawals from a SEP IRA taxed?
Yes, all withdrawals from a SEP IRA are taxed as regular income since you contributed to your plan with pre-tax dollars.
Is there any retirement plan that gives more tax deductions than the SEP IRA?
Yes, but only if you qualify for a Solo 401k and you’re 50 years of age or older. A Solo 401k has the same contribution limits as a SEP IRA, but also allows catch-up contributions for individuals who are at least 50 years.
Catch up contributions amount to $7,500 for 2024 and $7,500 for 2025. If you’re at least 50, that means you can contribute up to $76,500 for 2024 and $77,500 for 2025.
A Solo 401k also comes with a Roth option. In order to get the full tax deduction, you’ll have to make all your contributions into a Traditional Solo 401k, not the Roth Solo 401k.
If you’re over the age of 50 and qualify for a Solo 401k, you can get a tax deduction of up to $76,500 for 2024 and $77,500 for 2025. This is the largest possible tax deduction you can get from any retirement plan.
Also read: SEP IRA vs Solo 401k