9.3 SEP Contribution Limits (25% up to \$72,000 for 2026) and SECURE 2.0 Roth SEP Option

Statutory Contribution Limits (IRC § 404(h) and § 415(c))

Simplified Employee Pension plans operate under strict statutory funding limitations governing the maximum deductible employer contribution. Codified under Internal Revenue Code (IRC) Section 404(h)(1)(C) and Section 415(c)(1)(A), the annual employer contribution made on behalf of any individual participant cannot exceed the lesser of two statutory ceilings:

1. The Percentage Limitation: 25% of the employee's eligible compensation for the calendar year; or
2. The Statutory Annual Additions Dollar Cap: The maximum dollar limitation established under IRC Section 415(c)(1)(A), indexed annually for inflation:
   • Tax Year 2023: $66,000
   • Tax Year 2024: $69,000
   • Tax Year 2025: $70,000
   • Tax Year 2026: $72,000 (IRS Notice 2025-67)

Basic W-2 Example: In 2024, an employee receives $120,000 in W-2 wages from an incorporated business maintaining a 25% SEP. The employer calculates 25% of $120,000 = $30,000. Because $30,000 is less than the $69,000 dollar cap for 2024, the employer may contribute and deduct the full $30,000 on behalf of the employee.

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The Annual Includible Compensation Cap (IRC § 401(a)(17))

When calculating employer contributions, an employer cannot consider an employee's total gross earnings without limitation. Under IRC Section 408(k)(3)(C) and Section 401(a)(17), the maximum annual compensation that may be taken into account for any individual participant is strictly capped:

• Tax Year 2023: $330,000
• Tax Year 2024: $345,000
• Tax Year 2025: $350,000
• Tax Year 2026: $360,000

The Math of High-Earner Capping

The interaction between the 25% percentage ceiling and the Section 401(a)(17) compensation cap establishes the exact salary threshold at which the Section 415(c) dollar cap takes effect:

• For Tax Year 2024: $345,000 × 25% = $86,250. However, the Section 415(c) ceiling caps the contribution at $69,000. Dividing $69,000 by 25% reveals that any employee earning $276,000 or more hits the absolute maximum contribution cap of $69,000. Earning $345,000, $500,000, or $1,000,000 yields the exact same $69,000 contribution.
• For Tax Year 2025: $350,000 × 25% = $87,500. With the Section 415(c) cap at $70,000, dividing $70,000 by 25% shows that an employee reaching $280,000 in compensation reaches the full $70,000 maximum allowable contribution.
• For Tax Year 2026: $360,000 × 25% = $90,000, but the Section 415(c) cap is $72,000, so compensation of $288,000 or more produces the maximum $72,000 contribution.

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The Uniform Contribution Rule and Annual Discretion (IRC § 408(k)(3))

Two foundational operating principles govern employer funding of a SEP:

1. The Uniform Percentage Mandate

Under IRC Section 408(k)(3)(A), contributions cannot discriminate in favor of highly compensated employees (HCEs). In an IRS model Form 5305-SEP, contributions must bear a uniform percentage relationship to the total compensation of each eligible employee. If an employer decides to contribute 15% of compensation for the business owner, the employer must contribute exactly 15% of compensation for every eligible employee.

Permitted Disparity Note: While non-model prototype and individually designed SEPs may integrate contributions with Social Security (permitted disparity under IRC § 401(l)), model Form 5305-SEP strictly prohibits permitted disparity. Under Form 5305-SEP, the contribution percentage must be identical across all participants.

2. Discretionary Annual Funding

Unlike money purchase pension plans or certain contractual benefit formulas, a SEP requires zero mandatory annual funding commitment. The employer possesses complete annual discretion:

• In a highly profitable year, the employer may contribute the maximum 25%.
• In a lean year, the employer may reduce the contribution to 5% or 10%.
• In an unprofitable year, the employer may contribute 0%.

The employer is not required to show economic hardship to skip a year. However, whatever contribution percentage is selected for a given year must be applied uniformly to all eligible participants.

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Self-Employed Net Earnings & The Algebraic Rate Adjustment

A critical technical calculation tested extensively on the CISP examination is the determination of SEP contributions for self-employed individuals (sole proprietors, independent contractors, and general partners filing Schedule C, Schedule F, or Form 1065 Schedule K-1).

The Circular Calculation Dilemma

For common-law employees, compensation is straightforward W-2 wages. But for an unincorporated business owner, "compensation" is defined under IRC Section 401(c)(2) as net earnings from self-employment. Under federal tax law, net earnings must be adjusted by two mandatory statutory deductions:

1. The deduction for one-half (50%) of self-employment tax allowed under IRC Section 164(f); and
2. The deduction for the SEP retirement contribution itself under IRC Section 404.

Because the retirement contribution reduces the very net earnings on which the contribution is based, an unadjusted 25% calculation would result in an illegal over-contribution. To resolve this circular dependency, the Internal Revenue Service requires an algebraic rate adjustment.

The Rate Conversion Formula

To find the effective contribution rate for a self-employed individual, the stated plan rate is converted using the statutory algebraic formula:

Effective Self-Employed Rate = Stated Plan Rate ÷ (1 + Stated Plan Rate)

Applying this formula to standard plan contribution rates:

• 25% Stated Plan Rate: 0.25 ÷ (1 + 0.25) = 0.25 ÷ 1.25 = 20.0000%
• 20% Stated Plan Rate: 0.20 ÷ (1 + 0.20) = 0.20 ÷ 1.20 = 16.6667%
• 15% Stated Plan Rate: 0.15 ÷ (1 + 0.15) = 0.15 ÷ 1.15 = 13.0435%
• 10% Stated Plan Rate: 0.10 ÷ (1 + 0.10) = 0.10 ÷ 1.10 = 9.0909%
• 5% Stated Plan Rate: 0.05 ÷ (1 + 0.05) = 0.05 ÷ 1.05 = 4.7619%

Thus, when an incorporated employer contributes 25% of W-2 wages for employees, an unincorporated sole proprietor contributes an effective rate of 20% of net self-employment earnings after deducting half of self-employment tax.

Comprehensive Worked Mathematical Example

Sarah operates an unincorporated architectural consulting firm as a sole proprietor in 2024. Her business produces a gross Schedule C net profit of $200,000.

Step 1: Compute Self-Employment Tax and the 50% Deduction

• Net Schedule C profit: $200,000
• Net earnings subject to SE tax: $200,000 × 0.9235 = $184,700
• Social Security tax portion: The 2024 Social Security wage base is $168,600. The 12.4% OASDI tax applies up to $168,600: $168,600 × 12.4% = $20,906.40.
• Medicare tax portion: 2.9% applies to the entire $184,700: $184,700 × 2.9% = $5,356.30.
• Total Self-Employment Tax = $20,906.40 + $5,356.30 = $26,262.70.
• 50% Self-Employment Tax Deduction (IRC § 164(f)): $26,262.70 ÷ 2 = $13,131.35.

Step 2: Calculate Adjusted Net Earnings

• Net Profit ($200,000) minus 50% SE Tax Deduction ($13,131.35) = $186,868.65.

Step 3: Apply the 20% Effective Rate for a 25% Plan

• Sarah maintains a maximum 25% plan. Her effective rate is 20%.
• Maximum Deductible SEP Contribution: $186,868.65 × 20.0000% = $37,373.73.

Step 4: Mathematical Verification Proof

• Adjusted earnings after SEP deduction: $186,868.65 - $37,373.73 = $149,494.92.
• Stated plan rate applied to net earnings: $149,494.92 × 25% = $37,373.73! The algebraic proof confirms compliance down to the exact cent.

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SECURE 2.0 Act Section 601: The Roth SEP Revolution

For more than four decades following the inception of SEPs in 1978, all employer contributions were required by statute to be deposited on a pre-tax basis into Traditional IRAs. Section 601 of the Setting Every Community Up for Retirement Enhancement 2.0 Act of 2022 (SECURE 2.0) enacted a monumental change, amending IRC Section 408(k) to authorize Roth SEP IRAs effective for taxable years beginning after December 31, 2022.

Operational Rules under IRS Notice 2024-2

The Treasury Department and IRS issued operational guidance in IRS Notice 2024-2 clarifying the mechanics of Roth SEP contributions:

1. Employer Discretion to Offer: An employer is not required to offer a Roth option. However, if the employer chooses to amend its plan to permit Roth contributions, each eligible employee must be afforded the right to elect whether all or a portion of their SEP contribution will be treated as a Roth contribution.
2. Immediate Income Inclusion: A Roth SEP contribution is not excludable from the employee's gross income. The entire dollar amount contributed is treated as taxable compensation to the employee for the taxable year in which the contribution is deposited.
3. No Withholding, FICA, or FUTA: Notice 2024-2 (Q&A K-6) states that employer SEP contributions made to a Roth IRA are not wages for federal income tax withholding, Social Security and Medicare (FICA), or FUTA purposes (IRC §§ 3401(a), 3121(a)(5)(C), and 3306(b)(5)(C)). Because nothing is withheld, the employee may need to increase withholding or make estimated tax payments.
4. Reporting Mechanism: Under Notice 2024-2 (Q&A K-5), the contribution is reported on Form 1099-R, not Form W-2, for the year it is made to the Roth IRA, as if it had gone to a traditional IRA and been converted immediately: the total in Boxes 1 and 2a, code 2 or 7, and the IRA/SEP/SIMPLE box checked. It is income for the year deposited even if the employer deducts it for the prior year (Q&A K-4). Employers may keep using Form 5305-SEP or an approved prototype until the IRS updates its forms (Q&A K-7).
5. Tax-Free Growth and Distribution: Roth SEP funds are deposited directly into the participant's designated Roth IRA. Once deposited, they are governed by standard Roth IRA distribution ordering rules under IRC Section 408A: investment earnings accumulate completely income-tax-free, and qualified distributions (satisfying the 5-year holding requirement and taken after age 59½, death, or disability) are 100% exempt from federal and state income taxes.

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Grandfathered SARSEPs (Salary Reduction Simplified Employee Pensions)

Under IRC Section 408(k)(6), Congress previously permitted small employers to maintain Salary Reduction Simplified Employee Pensions (SARSEPs), which allowed employees to make elective pre-tax salary deferrals directly into their SEP IRAs.

The 1996 Legislative Sunset

The Small Business Job Protection Act of 1996 repealed SARSEPs effective December 31, 1996, replacing them with SIMPLE IRA plans starting January 1, 1997. No new SARSEPs could be established after December 31, 1996.

Ongoing Administration of Grandfathered SARSEPs

Existing SARSEPs established on or before December 31, 1996 were grandfathered by statute and may continue to operate indefinitely, subject to strict ongoing compliance rules:

• 25-Employee Restriction: The employer must have had no more than 25 eligible employees at any time during the entire preceding calendar year.
• 50% Participation Mandate: At least 50% of all eligible employees must actively choose to make salary reduction deferrals in the plan year.
• Elective Deferral Limits: Participant elective deferrals are governed by the annual qualified plan limit under IRC Section 402(g): $23,500 for 2025 and $24,500 for 2026, plus age 50+ catch-up contributions ($7,500 for 2025 and $8,000 for 2026, with a higher $11,250 limit for ages 60–63 in both years).
• SARSEP Non-Discrimination Testing: SARSEPs must satisfy an annual numerical non-discrimination test: the deferral percentage of each highly compensated employee (HCE) cannot exceed 125% of the average deferral percentage of all non-highly compensated employees.

Plan Features Comparison Matrix

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Realistic Bank Administrative Scenario: Multi-Employee Corporate Funding & SECURE 2.0 Roth Election

At First Horizon Wealth Management, CISP operations officer Elena processes 2024 retirement plan contributions for Sterling Engineering Inc., an S corporation maintaining a SEP plan.

Corporate Profile & Compensation Roster

For calendar year 2024, Sterling Engineering declares a uniform 15% employer SEP contribution. The corporation's employee roster consists of:

1. Arthur (President & Majority Shareholder): W-2 compensation of $360,000;
2. Beatrice (Senior Engineer): W-2 compensation of $140,000;
3. Charles (Junior Designer): W-2 compensation of $50,000.

Sterling Engineering recently adopted an amendment authorizing the SECURE 2.0 Roth SEP contribution feature for 2024. Charles submits a formal election directing the company to designate 100% of his 2024 SEP contribution as a Roth SEP contribution.

Contribution Calculations and Compliance Protocol

1. Arthur (Compensation Cap Analysis):
   • Arthur's W-2 compensation is $360,000. Under IRC Section 401(a)(17), his includible compensation is capped at $345,000 for 2024.
   • Uniform rate calculation: 15% × $345,000 = $51,750.
   • Section 415(c) ceiling check: $51,750 is well below the $69,000 statutory limit. Elena processes a $51,750 pre-tax contribution into Arthur's Traditional SEP IRA.
2. Beatrice (Standard Uniform Calculation):
   • Beatrice's compensation is $140,000.
   • 15% × $140,000 = $21,000.
   • Elena deposits $21,000 pre-tax into Beatrice's Traditional SEP IRA.
3. Charles (SECURE 2.0 Roth SEP Execution):
   • Charles's compensation is $50,000.
   • 15% × $50,000 = $7,500.
   • Elena confirms that Charles has established a designated Roth IRA at First Horizon.
   • On December 16, 2024, the corporation transfers $7,500 directly into Charles's Roth IRA.
   • Tax and Payroll Accounting: Elena explains that under IRS Notice 2024-2, the $7,500 is reported on a 2024 Form 1099-R (code 2 or 7 with the IRA/SEP/SIMPLE box checked), not on Form W-2, because it was deposited in 2024. It is taxable income to Charles for 2024 but is not subject to income tax withholding, FICA, or FUTA, so Charles may want to adjust his own withholding.
   • Charles's $7,500 contribution enters his Roth IRA with zero pre-tax deferral, beginning its journey toward qualified, tax-free distribution under IRC Section 408A.