SEP IRAs: THE BASICS OF MAKING A PRIOR-YEAR CONTRIBUTION

It’s the time of year when we get a lot of questions from self-employed people who wonder about making a contribution to a SEP IRA. Perhaps your tax preparer has mentioned it, or you have heard rumors that contributing to a SEP can be a good thing for your tax profile.

Making a SEP contribution means a bit more coordination and collaboration with your tax preparer than most other types of retirement plan contributions. Here are some tips for a smooth process.

SEP IRAs are different from other retirement plans in that the contribution limit is determined by how much net self-employment income you had during the calendar year; you can contribute up to 20% of your net income. However, because determining net income may be tricky (thanks to a variety of deductions that you may be able to take), the best practice is to essentially complete your tax return (but don’t file it yet!) and allow your tax preparer (or Turbo Tax) to determine the amount of your contribution limit for the prior year.

Note that once you know the contribution limit, you aren’t obligated to contribute that amount – that’s just the upper limit. On the contrary, people are sometimes surprised by the amount they are able to contribute (if, say, their prior year’s income was higher than they thought). Sometimes people only have the resources to contribute a smaller amount. This is perfectly fine.

Once you determine how much you are going to contribute, tell your tax preparer. This step is important because without knowing how much you plan to contribute, he or she (or Turbo Tax) can’t note the contribution for the purpose of finalizing your tax return.

Circling back to your tax return and noting the contribution is critical because the contribution amount can be taken as an above-the-line deduction (the most advantageous kind!). You’ll see it noted on the front page of your tax return.

We’ve had clients who planned to make a SEP contribution – and indeed did – but didn’t tell their tax preparer, who in turn went ahead and filed their return without noting the contribution. So, the filed return was inaccurate to the client’s disadvantage – missing a significant deduction – and the return had to be amended.

A word about advantageous deadlines: SEP IRAs are special in that the deadline for contributions is whenever your tax return is filed, including extensions. This last part is important, as it potentially gives self-employed people until October 15th to make a contribution for the prior year. The extra few months can be useful if you have cash flow or savings constraints, and the extra time allows you to gather additional funding for a contribution.