How a SEP IRA Reduces Your Taxes: Deduction, Limits, and Deadlines

A SEP IRA reduces your taxes in two ways: the money you contribute is deducted from your income before tax is calculated, and everything the account earns grows tax-deferred until you withdraw it. For 2026, the contribution cap is the lesser of $72,000 or 25% of compensation, which makes it one of the most generous tax-advantaged retirement accounts available to small business owners and self-employed people.¹

How the Deduction Lowers Your Tax Bill

SEP IRA contributions are deductible under federal tax law.² The deduction is above-the-line, meaning it reduces your adjusted gross income directly, and you do not have to itemize to claim it.³ A lower AGI can drop you into a lower bracket and expand your eligibility for other income-based credits and deductions that phase out at higher incomes.

A simple example: if your business earns $100,000 and you contribute $20,000 to a SEP IRA, the IRS treats your taxable income as $80,000 for that year. The $20,000 is not taxed in the year you earned it. You pay income tax on it later, when you withdraw it in retirement.

One limit is worth naming up front. SEP contributions reduce your income tax, but they do not reduce self-employment tax. Social Security and Medicare taxes are calculated on your net self-employment earnings before the SEP contribution is subtracted, so your self-employment tax bill does not change no matter how much you put in.

How Much You Can Deduct in 2026

For the 2026 tax year, contributions cannot exceed the lesser of $72,000 or 25% of the employee’s compensation.¹ The compensation used in that calculation is capped at $360,000, so even higher earnings do not raise the ceiling.⁴ Both figures are adjusted annually for inflation.

The Self-Employed Math

If you are self-employed, the 25% limit does not work the way it does for W-2 employees. Your compensation for SEP purposes is your net self-employment earnings minus the deductible portion of your self-employment tax and minus the SEP contribution itself.⁵ Because the contribution is subtracted from the base it is calculated on, the effective maximum rate for a self-employed person is roughly 20% of net profit rather than 25%.⁶

IRS Publication 560 contains a Rate Table and a Deduction Worksheet for self-employed individuals that walk through this circular math.⁵ The general process:

Start with net profit from line 31 of Schedule C, or box 14 of Schedule K-1 if you are a partner.
Subtract half of your self-employment tax, which comes from Schedule SE and appears on Schedule 1 of Form 1040.
Apply the reduced rate from the Rate Table in Publication 560 rather than multiplying by 25%.

The Second Tax Benefit: Growth Without Annual Tax

The deduction is only half of the tax benefit. Investments inside a SEP IRA grow without triggering any tax along the way. In a regular taxable brokerage account, you owe tax each year on dividends, interest, and realized gains. Inside a SEP IRA, those earnings compound untouched, because nothing is siphoned off annually.

Over decades, the money that would have gone to yearly taxes stays invested and generates its own returns. You pay income tax on SEP funds only when you take them out, ideally in retirement, when many people find themselves in a lower bracket than during their peak earning years.⁷

When You Eventually Pay Tax

You cannot defer taxes on a SEP IRA forever. Once you reach age 73, you must begin taking required minimum distributions each year.⁸ Your first RMD is due by April 1 of the year after you turn 73. Every RMD after that is due by December 31.

Delaying that first RMD until April 1 means two taxable distributions in the same calendar year, which can push you into a higher bracket. Many account holders take the first distribution by December 31 of the year they turn 73 instead of waiting.⁸

If you take money out before age 59½, the distribution is included in your taxable income and is generally hit with an additional 10% early withdrawal tax, reported on Form 5329.⁹¹⁰ Several exceptions eliminate the 10% penalty, though income tax on the withdrawal still applies:

Total and permanent disability.
Unreimbursed medical expenses that exceed 7.5% of your AGI, up to the excess amount.
Health insurance premiums after you have received unemployment compensation for at least 12 weeks.
Up to $10,000 for a qualified first-time home purchase.
Qualified higher education expenses for you or your dependents.
Up to $5,000 per child for qualified birth or adoption expenses.
Distributions paid to beneficiaries after the account holder’s death.

The Roth SEP Alternative

Since 2023, employers sponsoring a SEP plan can offer employees the option of treating contributions as Roth, meaning after-tax rather than pre-tax.¹¹ With a Roth SEP contribution, there is no deduction in the year of the contribution. The trade is that qualified withdrawals in retirement, including all the investment growth, come out completely tax-free.

The Roth option is not automatic. The employer is not required to offer it, and if it is offered, each employee has to affirmatively elect it before the contribution is made. The employer cannot make the election for the employee. For reporting, the IRS treats employer Roth SEP contributions as if they were made to a traditional IRA and immediately converted to a Roth, so these amounts are reported on Form 1099-R rather than deducted on Schedule 1.¹¹

Which way makes sense depends on your tax outlook. If you expect a higher bracket in retirement, paying tax now through Roth contributions can save money long-term. If you expect a lower bracket, traditional pre-tax SEP contributions and the immediate deduction are typically the better call.

Reporting the Deduction on Your Return

Once you know your contribution amount, report the deduction on Schedule 1 of Form 1040, on the line for self-employed SEP, SIMPLE, and qualified plans (line 16 for sole proprietors and partners).⁵ The amount flows from Schedule 1 to Form 1040, reducing your AGI before you apply the standard or itemized deduction.

To calculate the correct amount, you will need:

Schedule C or Schedule K-1, showing your net self-employment earnings or partnership income.
Schedule SE, so you can pull the deductible half of your self-employment tax to adjust net profit.
The Deduction Worksheet for Self-Employed and Rate Table in Publication 560, which handle the circular math of the maximum contribution.⁵

If you contribute more than the limit, the excess is subject to a 6% excise tax for each year it stays in the account, reported on Form 5329.¹⁰ To fix it, withdraw the excess and any earnings on it before your filing deadline, or apply it toward the following year’s contribution limit.

Deadline to Set Up and Contribute

You can establish and fund a SEP IRA for a given tax year up to your tax filing deadline, including extensions.¹² A six-month extension gives you until mid-October to both open the plan and make your contribution for the prior year, which is useful if you want to see your final numbers before committing to an amount. Setting up the plan itself is done on IRS Form 5305-SEP, which you keep in your records rather than file with the IRS.¹³

Two Things That Can Undo the Tax Benefit

If you have employees, the deduction is not just about you. You must contribute to a SEP IRA for every eligible employee, and the contribution rate has to be the same percentage of compensation for everyone, including yourself.¹⁴¹⁵ The cost of covering staff is a real factor when weighing the size of your own deduction.

Certain transactions with your SEP IRA are prohibited, and the penalty is severe. Borrowing from the account, selling property to it, using it as loan collateral, or buying property for personal use with account funds triggers a rule under which the IRS treats the entire account as distributed to you on the first day of that year.¹⁶ The full balance above your cost basis becomes taxable income, and if you are under 59½, the 10% early withdrawal penalty applies on top of that. The tax shelter you built with years of deductions can be wiped out by one prohibited transaction.

1
Internal Revenue Service. Notice 25-67 – 2026 Amounts Relating to Retirement Plans and IRAs
2
Office of the Law Revision Counsel. 26 USC 404 – Deduction for Contributions of an Employer to an Employees Trust or Annuity Plan and Compensation Under a Deferred-Payment Plan
3
Office of the Law Revision Counsel. 26 USC 62 – Adjusted Gross Income Defined
4
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
5
Internal Revenue Service. Publication 560, Retirement Plans for Small Business
6
Internal Revenue Service. Self-Employed Individuals: Calculating Your Own Retirement Plan Contribution and Deduction
7
Internal Revenue Service. Retirement Plans FAQs Regarding IRAs Distributions (Withdrawals)
8
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
9
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
10
Internal Revenue Service. About Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts
11
Internal Revenue Service. SECURE 2.0 Act Changes Affect How Businesses Complete Forms W-2
12
Internal Revenue Service. Retirement Plans FAQs Regarding SEPs
13
Internal Revenue Service. Form 5305-SEP, Simplified Employee Pension Individual Retirement Accounts Contribution Agreement
14
Internal Revenue Service. Simplified Employee Pension Plan (SEP)
15
Office of the Law Revision Counsel. 26 USC 408 – Individual Retirement Accounts
16
Internal Revenue Service. Retirement Topics – Prohibited Transactions