The SEP-IRA “25% rule”: why your real limit is closer to 18%

Every source says a SEP-IRA lets you contribute 25%. Then you put your numbers into a calculator and get a figure nearer 18%. Neither is a mistake — they are measuring different things, and the gap is large enough to cause a real over-contribution.

The 25% is of compensation, not profit

The limit is 25% of compensation. For an employee that word is unambiguous: it is their W-2 wages, a number that exists before the contribution is made.

A self-employed person has no wages. There is only net profit, and the IRS defines the base as net earnings from self-employment — net profit, minus the deductible half of self-employment tax, minus the contribution itself.

That last clause is the whole problem. The contribution reduces the base used to calculate the contribution.

The circular calculation, resolved

Write it out and it solves cleanly:

contribution = 0.25 × (base − contribution)
contribution = 0.25 × base − 0.25 × contribution
1.25 × contribution = 0.25 × base
contribution = base × (0.25 ÷ 1.25) = base × 0.20

So the effective rate against net earnings is 20%, not 25%. Same limit, stated from the other side of the equation. This is why IRS Publication 560’s rate table shows 0.2000 for a self-employed person whose plan says 25%.

But 20% is still not 20% of your profit

The 20% applies to net earnings, which is already smaller than net profit. Run it end to end on $100,000 of profit:

Step	Amount
Net profit	$100,000
Less deductible half of self-employment tax	−$7,065
Net earnings (the base)	$92,935
× 20%	$18,587

$18,587 — which is 18.6% of the profit you started with. Someone applying “25%” to $100,000 would contribute $25,000 and be over by $6,413.

The ratio is stable across most incomes, because the self-employment tax deduction moves with profit:

Net profit	Maximum SEP contribution	As a share of profit
$60,000	$11,152	18.6%
$100,000	$18,587	18.6%
$150,000	$27,881	18.6%
$400,000	$72,000	18.0% (capped)

It drifts upward only at high income, where Social Security tax stops applying to the extra profit so the deduction stops growing proportionally — and then the overall cap takes over anyway. For 2026 that cap is $72,000.

Where the 25% genuinely is 25%

The rule is not wrong, it is just about a different person.

If your business is an S-corp and you pay yourself a W-2 salary, the SEP contribution really is 25% of that salary. There is no circularity, because the salary is fixed before the contribution and the company — not you — makes it. A $100,000 salary supports a $25,000 contribution.

That is a genuine planning difference between structures, and it is one of the few places where the S-corp election helps with something other than self-employment tax. It is not free: the salary has to be reasonable, and it carries payroll tax and filing costs. See sole proprietor vs LLC vs S-corp.

What happens if you over-contribute

This is not a rounding-error problem. An excess contribution is subject to a 6% excise tax for every year it stays in the account, not once — so an excess left alone quietly compounds a penalty.

The fix is straightforward if you catch it in time: withdraw the excess, plus the earnings attributable to it, by your tax filing deadline including extensions. Do that and the 6% does not apply for that year.

Which is the practical reason to take the arithmetic seriously rather than contributing “a quarter of what I made” and correcting later.

The short version

• 25% is of compensation, which self-employed people do not have.
• Against net earnings, the same limit is 20%.
• Against net profit — the number in your head — it works out near 18.6%.
• The 2026 overall ceiling is $72,000.
• With an S-corp salary, it really is 25% of the salary.

If you want more shelter than this at a middling income, the answer is usually not a bigger SEP but a different plan: a solo 401(k) adds an employee deferral on top of the same employer percentage, which is worth $24,500 more at every income level covered above. That comparison is its own guide.

The calculator below runs the full sequence on your own profit.