IRA Rules

Archive for October, 2008

Question: Why is there a SEP IRA compensation limit?

I am at a new company and they offer a SEP IRA plan for me to contribute to. I
was reading over the rules for a SEP IRA and I had a question about the
contribution limits. The rules I saw for 2006 show that a person can contribute
is 25% of their compensation or $44,000. I saw there is a salary cap of
$220,000. I was wondering why there is a salary cap that high because $44,000
is 25% of $176,000. Is there a reason for the salry cap and if there is, what is
it?

Thanks

Answer: SEP-IRA Deducton and Contribution Limits
Today’s tax question comes from D. Singleton in Texas. He asks:
“Your article SEP, SIMPLE, Retirement Plan Contribution Deduction contains the following quote: ‘Limits: Your maximum contribution to a SEP-IRA is 20% of your self-employment income or $42,000, whichever is less.’ Shouldn’t this be 25%? Everything else I’ve read says 25%. Please clarify.”

You can contribute 25% of your wages to a SEP-IRA, if you are an employee participating in your employer’s retirement plan.

If you are self-employed, however, you do not have wages. Instead, you have net profits from the business venture. Self-employed people can contribute 20% of your net profits* up to $42,000 (increases to $44,000 for 2006). Now net profits for the SEP-IRA are calculated differently. You take your net self-employment income and subtract one-half of your self-employment taxes. The resulting “net net” self employment income is then multiplied by 20% to get your contribution amount.

This lower 20% rate is well-documented in IRS Publication 560, Retirement Plans for Small Business. See the section on Contribution Limits, and scroll down to “Tax treatment of excess contributions.”

J.K. Lasser’s Your Income Tax has an excellent chapter on retirement plan options for self-employed people. You will want to read chapter 41 of the JK Lasser book to learn more about SEP and other retirement plans.

Fidelity Investments has an excellent SEP-IRA Calculator to determine your maximum contribution. I am in no way recommending you invest through Fidelity. I just like using their calculator.

One final tip. You have until your final deadline, including extensions, to contribute to a SEP-IRA for last year. So if you file an extension, you will have until October 16, 2006, to fund your SEP-IRA for last year. However, you do have to fund the SEP before you file your tax return. If you don’t file for an extension, the last day you can contribute to a SEP would be April 17, 2006.

SEP vs. IRA

Question: Should I have 10% withheld from an rollover IRA distribution?

I’ve rolled a significant amount of money from my 401K to a Roll-over IRA to be used as a down payment on a house. I am now ready to transfer the money from the IRA to my savings account.

I have the option to have the 10% early withdrawal penalty withheld or not; with the following warning: “Regardless of your withholding election, you are responsible for the full payment of any federal income taxes, any state or local taxes and any penalties that may apply to your distribution. You may be responsible for estimated tax payments and could incur penalties if your estimated tax payments are not sufficient.”

What potential penalties do I face if I elect not to withhold and put the money in an interest earning savings account until next tax season?

Answer: In addition to all you stated, the IRS will also penalize you for not pre paying at least 90 % of your tax for that particular year, that is the reason for withholding, so they get their share before you file.