Why 20% Is the Real SEP-IRA Rate (Not 25%) for Self-Employed

The short version

25% of compensation after the SEP contribution = 20% of compensation before the SEP contribution. Same number, different starting point.

For W-2 employees, compensation (wages) is fixed — you multiply by 25%, done. For self-employed people, net earnings are reduced by the contribution itself, which makes the calculation circular. Solving that circular equation gives you 20%.

The algebra

Let:

• N = net self-employment income (adjusted for half SE tax)
• C = SEP contribution

IRS rule: C ≤ 25% × (N − C)

Solve:

• C ≤ 0.25N − 0.25C
• 1.25C ≤ 0.25N
• C ≤ 0.25N / 1.25
• C ≤ 0.20N

So the maximum C is 20% of N. Not 25%. The 25% rule is applied to compensation after subtracting C, which creates the circular dependency.

Why the IRS doesn't just say 20%

Because the 25% rule is stated uniformly across SEP plans — for W-2 employees, it's straightforwardly 25% of wages. Wages aren't reduced by the contribution (they're set by payroll). So for a W-2 person, 25% just means 25%.

For self-employed people, "compensation" is net earnings from self-employment reduced by the contribution itself. Apply the 25% rule to that reduced compensation and the math collapses to 20% of the pre-reduction compensation.

Worked example

Net SE earnings (after half-SE-tax adjustment): $100,000

Wrong (using 25% naively): $100,000 × 25% = $25,000 max contribution. This is too high.

Right (using 20%): $100,000 × 20% = $20,000 max contribution.

Verify the right answer: If C = $20,000, then N − C = $80,000. 25% of $80,000 = $20,000 ✓. The 25% rule holds.

If you'd used $25,000: N − C = $75,000. 25% of $75,000 = $18,750. But you contributed $25,000. Over the limit — the IRS would require you to return the excess plus earnings.

How tax software handles it

TurboTax and FreeTaxUSA both do this correctly. You enter your Schedule C profit; they compute the max. You don't need to do the math by hand.

But online calculators and "quick tip" articles often get it wrong. If you see "25% of your net profit" as a SEP-IRA formula without caveats, the author misunderstood the rule.

The full calculation (start to finish)

1. Net profit on Schedule C Line 31: let's call this P
2. Adjusted net SE earnings: P × 0.9235 (the 7.65% SE tax exclusion)
3. SE tax: P × 0.9235 × 0.153
4. Half-SE-tax deduction: step 3 ÷ 2
5. Net earnings for SEP purposes: P − step 4
6. Max SEP contribution: step 5 × 0.20
7. Cap at $70,000 (2025)

Use our SEP-IRA calculator to run these numbers automatically.

S-Corp owners: back to 25%

If you're an S-Corp owner contributing via W-2 wages, the 25% rule applies directly to your W-2 wages. No circular math. If you pay yourself $100,000 W-2, your max SEP contribution is $25,000.

This is one of the minor advantages of the S-Corp election — cleaner retirement math. Though in most cases the SE-tax savings dominate.

The common trap when planning