QOTW: Contributions to SEP-IRA and traditional IRA

A self-employed taxpayer contributed $5,000 each to a SEP-IRA and a traditional IRA. Is either contribution limited by the other?

December 12, 2019

Q. Can a self-employed consultant contribute to both a Simplified Employee Pension (SEP)-IRA and traditional IRA?

A retired client started a consulting business in 2019. She contributed $5,000 to a SEP-IRA. She also made a traditional IRA contribution of $5,000, for total contributions of $10,000. Is her IRA contribution limited by the SEP, or the other way around? She will file a Schedule C.

A. The SEP-IRA and traditional IRA contribution maximums are not limited by one another. However, other limitations may apply.

SEP-IRA

In general, the maximum SEP contribution deduction for the client (i.e. the business owner) is the lesser of 20% of net earnings from self-employment or $56,000 (for 2019). For this purpose, net earnings from self-employment also takes into account the deduction for one-half of self-employment tax and the SEP-IRA contribution deduction itself. Because net earnings and the SEP-IRA contribution are interdependent, a special computation is needed to figure the maximum deductible contribution.

See Chapter 5 in IRS Pub. 560, Retirement Plans for Small Business for worksheets that can be used for figuring the deduction. Although your client has not contributed anything close to the overall maximum, make sure she had sufficient net earnings to cover her $5,000 contribution. Excess contributions may be carried over to 2020 if not withdrawn but may be subject to the 10% excise tax.

Traditional IRA

The maximum contribution to an IRA for 2019 is $6,000 ($7,000 if the taxpayer is at least 50). Although traditional (and Roth) IRA maximums are not reduced by SEP and other contributions to self-employed plans, there is a connection. The traditional IRA contribution is limited to taxable compensation which, for a self-employed taxpayer, is essentially the same as net earnings from self-employment. That means net profits must be reduced by the deduction for one-half of self-employment tax and the SEP-IRA contribution. Thus, you need to compute the SEP-IRA contribution deduction to make sure your client has sufficient taxable compensation to cover her traditional IRA contribution.

The SEP-IRA may also affect her IRA deduction. She is treated as participating in an employer retirement plan. Depending on her modified AGI and filing status, her deduction could be reduced or eliminated. See IRA Deduction if You Are Covered by a Retirement Plan at Work. If your client is unable to deduct the full amount of her contribution, she can treat the excess as a non-deductible contribution or consider recharacterizing the non-deductible amount as a Roth IRA.

Originally published in the 12/11/19 edition of TAX in the News

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