How Self‑Employed Taxpayers Compute Compensation for SEP Contributions

Self-employed workers across the United States saw a quiet but important reminder in 2025 tax guidance: the money they can put into a retirement plan still depends on a special “circular” calculation based on their net earnings from self-employment, not on a simple wage number.

As of August 27, 2025, the Internal Revenue Service continues to direct sole proprietors and partners to figure their “compensation” for plan purposes by taking business net income, subtracting the employer‑equivalent part of self‑employment tax—set at 7.65%—and then subtracting the deduction for their own retirement plan contribution. Because that deduction itself depends on those net earnings, the process loops back on itself. To break that loop, filers must adjust the plan’s stated rate using the formula: rate ÷ (1 + rate).

This method matters more in 2025 because the SEP IRA ceiling rose to $70,000, with a 25% limit based on compensation and a compensation cap of $350,000. For many immigrant small‑business owners and independent professionals, a mistake on this math can shrink savings or trigger corrections at tax time.

How compensation is defined for self‑employed owners

• Compensation for plan purposes is net earnings from self‑employment, but only when personal services are an actual part of the business producing income.
• Start with gross income from the trade or business, subtract normal business expenses to get net income, then:
  1. Subtract the employer‑equivalent portion of self‑employment tax (7.65% of net income).
  2. Subtract the deduction for the owner’s own retirement plan contribution.
• The final step creates the circularity because the deduction depends on the compensation figure. The IRS resolves this by directing filers to reduce the stated plan rate using the fraction rate ÷ (1 + rate).

Example: if a SEP specifies 25% employer contributions, a self‑employed owner uses an adjusted rate of 0.25 ÷ 1.25 = 0.20 (20%), applied to net earnings after the self‑employment tax reduction. That adjusted rate produces the correct deduction without overcounting.

Key 2025 limits and practical effect

• SEP IRA maximum contribution: $70,000 (2025).
• Plan contribution limit per person: 25% of compensation.
• Compensation cap for 2025: $350,000.
• Because the 25% limit applies to compensation after required reductions, many filers hit the percentage limit before the dollar cap.
• For sole proprietors, the practical working figure is often the 20% adjusted rate when the plan rate is 25%, after removing the 7.65% employer‑equivalent tax portion from net income.
• If you have common‑law employees, the plan rate must be uniform for all eligible workers. You still run the rate‑reduction step for the owner’s share.

Peter’s worked example (simple walk‑through)

Peter is a sole proprietor with $100,000 of net income on Schedule C:

1. Employer‑equivalent portion of self‑employment tax: $7,650 (100,000 × 7.65%).
2. Net after tax portion: $92,350.
3. Plan’s stated rate: 25%. Adjusted owner rate: 0.25 ÷ 1.25 = 0.20 (20%).
4. Owner’s SEP contribution: $18,470 (92,350 × 20%).
5. Compensation after owner contribution: $73,880 (92,350 − 18,470).

Quick check: Start from $100,000 − $7,650 − $18,470 = $73,880; then 25% of $73,880 = $18,470. The loop is closed and the numbers match.

Another quick example (owner with $160,000 net income):
– Employer‑equivalent tax portion: $12,240 (160,000 × 7.65%).
– Net after tax portion: $147,760.
– Adjusted owner rate (25% plan): 20%.
– Owner contribution: $29,552 (147,760 × 20%).
– Confirm: 160,000 − 12,240 − 29,552 = $118,208, and 25% of 118,208 = $29,552.

A few ground rules (summary)

• Compensation is net earnings from self‑employment (when personal services matter).
• Before applying the adjusted rate, reduce net income by the 7.65% employer‑equivalent self‑employment tax.
• Apply the adjusted rate (rate ÷ (1 + rate)) to that reduced net earnings figure to find the owner’s contribution and deduction.
• The owner’s contribution is not a business expense for their own benefit; it’s taken as an adjustment to income on Schedule 1 (Form 1040).
• Employer contributions for employees are deductible business expenses, and the contribution rate must be uniform for eligible employees.
• Items excluded from gross income generally do not enter net earnings from self‑employment—except for foreign earned income and foreign housing amounts.
• Partner rules:
  • A partner’s distributive share (except separately stated items like capital gains/losses) counts toward net earnings from self‑employment.
  • Guaranteed payments for services to limited partners count as net earnings from self‑employment; other distributive shares to limited partners do not.
• Income passed through to S corporation shareholders does not count as net earnings from self‑employment for this calculation.
• Roth contributions for the owner’s own account are not deductible; Roth contributions for employees are a deductible business expense.

Step‑by‑step process to get the correct owner contribution

1. Find net income on Schedule C (Form 1040) or other business schedule.
2. Compute employer‑equivalent share of self‑employment tax at 7.65%, and subtract it.
3. Adjust the plan’s rate with rate ÷ (1 + rate).
4. Apply the adjusted rate to the reduced net earnings to compute the owner’s contribution and deduction.
5. Quick check: net income − 7.65% amount − contribution = compensation base such that the plan’s full rate × that base = your contribution.
6. Report the deduction as an adjustment to income on Schedule 1 (Form 1040).

Deadlines, corrections, and practical notes

• SEP contribution deadline for the 2025 tax year: the due date of the tax return, including extensions.
• Employer contributions to SEP IRAs are deductible within limits; excess amounts must be corrected to avoid penalties.
• If employees are on payroll, the uniform contribution rate rule can affect cash‑flow planning.
• The IRS offers worksheets and guidance in Publication 560 for the circular math.
• For owners who wait until books are finalized (often near filing time), the deadline flexibility helps make precise contributions.

Important: Use the adjusted rate to avoid overcontributions or understating your deduction. You cannot deduct a contribution based on a number that already assumes that same contribution.

Common mistakes to avoid

• Treating the owner’s contribution as a business expense on the business schedule rather than as an adjustment to income on Schedule 1 (Form 1040).
• Using the plan’s full 25% rate on the owner’s net income without applying rate ÷ (1 + rate).
• Forgetting to subtract the 7.65% employer‑equivalent self‑employment tax before applying the adjusted rate.
• Ignoring the $350,000 compensation cap for 2025.
• Claiming a deduction for the owner’s Roth contribution.
• Failing to apply a uniform contribution rate for eligible employees.
• Counting S corporation pass‑through income as net earnings from self‑employment for this calculation.
• Missing special rules for limited partners and guaranteed payments.

Practical impact and audience

• The calculation affects decisions about how much to save, when to fund the account, and how to handle employee benefits.
• For a first‑year immigrant consultant, the math helps decide how much cash to set aside while paying quarterly taxes and covering living costs.
• For a family shop hiring employees, the owner must budget for the uniform plan rate and compute their personal deduction correctly.
• For partners, reviewing the partnership K‑1 is essential to identify what counts toward net income from self‑employment.

Resources and references

• Official IRS worksheets and guidance: see Publication 560 at the IRS website.
• Forms and schedules:
  • Schedule C (Form 1040) — business income and expenses
  • Schedule SE (Form 1040) — self‑employment tax
  • Schedule 1 (Form 1040) — deduction for the owner’s contribution

Official links:
– IRS Publication 560: Retirement Plans for Small Business — Publication 560
– Schedule C (Form 1040): About Schedule C (Form 1040)
– Schedule SE (Form 1040): About Schedule SE (Form 1040)
– Schedule 1 (Form 1040): About Schedule 1 (Form 1040)

Final takeaway

To close the loop in simple terms: the owner’s compensation for plan purposes comes from net business income, reduced by 7.65% for the employer portion of self‑employment tax and then by the owner’s own plan deduction. Because the deduction depends on compensation, the adjusted rate (plan rate ÷ (1 + plan rate)) keeps the math consistent. The 2025 limits—25% of compensation, capped at $70,000, with a $350,000 compensation cap—set the outer boundaries. Inside those lines, following the steps above helps self‑employed taxpayers set a correct, on‑time contribution that stands up at filing and supports long‑term savings.