Your client wants to know whether she can contribute after Dec. 31, 2008, to a SEP-IRA set up in that year, but to which no contributions were made in 2008, in order to reduce her modified adjusted gross income.
Situation:
Your client wants to know whether she can contribute after Dec. 31, 2008, to a SEP-IRA set up in that year, but to which no contributions were made in 2008, in order to reduce her modified adjusted gross income.
Your client spent her New Year’s Day reviewing her financial statements from the consulting business she started in February 2008. Since she was so busy during 2008, she did not have time to keep her accounting and bookkeeping information up-to-date. She did not realize that she had made a profit of $125,000, her only income for the year.
The client hired one employee during the year to assist with the managing the office and processing reports. At the time of the hire, she created a simplified employee pension individual retirement account. However, contributions were not made to the retirement plan during 2008.
She did not incorporate her consulting business and will be filing a Schedule C with her Form 1040 for tax year 2008.
Solution:
Individual taxpayers are cash basis, which means they are required to include all income in the year earned, and deduct all expenses in the year paid.
However, according to Internal Revenue Code Section 404(a)(6), a deductible contribution to a retirement plan is considered made on the last day of the tax year if it is paid no later than the due date of the taxpayer’s return including extensions.
As such, your client can still make a deductible contribution to the SEP-IRA that she created in 2008. She will be required to contribute on behalf of her employee as well as herself.
If her employee earned $25,000 in 2008, she would calculate the maximum contribution as follows:
$25,000 x 25% = $6,250
To calculate her deductible contribution to the retirement plan, she must consider half of the self-employment tax. Under a simple calculation, the SE tax is: $125,000 x 15.3% = $19,125. Therefore, the calculation for your client’s contribution is as follows:
Schedule C income $125,000
Employee’s retirement contribution (6,250)
½ SE tax ( 19,125)
Earnings considered $ 99,625
“Percent equivalent adjustment” 20%
Your client’s contribution $ 19,925
The contribution to a SEP-IRA is limited to the lesser of 25% of the participant’s compensation or $46,000.
An employee may make contributions to their SEP-IRA in addition to the employer’s contribution. However, these contributions are subject to the annual maximums and must consider gross income.
All contributions to the SEP-IRA will be required by April 15, 2009, unless both the employee and the client file an extension. If an extension is filed by both, then the contribution may be made by Oct. 15, 2009.
Since your client’s modified AGI exceeds the phase-out of $63,000, she will not be able to make an additional contribution to the SEP-IRA.
By making the suggestion to contribute to the SEP-IRA, you have decreased her AGI by $26,175.
Assuming she has no itemized deductions and will be using the standard deduction, her taxable income is reduced to $70,750:
$99,625 (Schedule C earnings) minus $19,925 (retirement contribution) minus $5,460 (standard deduction) minus $3,500 (personal exemption)
The contribution to the SEP-IRA changes your client’s tax obligation from the 28% bracket to the 25% bracket. If she has itemized deductions, her taxable income will be decreased further.
