It is also known as a SEP-IRA because separate Individual Retirement Accounts (IRA)are set up for you and each of your eligible employees. 
You, as the employer, then make yearly contributions to each of these IRA accounts. 
The maximum amount that you can contribute to each employee's SEP-IRA is limited to 25% of the employee's compensation but cannot exceed $51,000 for 2013. The 2014 SEP-IRA maximum contribution is raised to $52,000.
Your self-employment tax on $86,000 would be $12,151 and you are allowed a one-half deduction which would be $6,076. 

Since your net sole proprietorship earnings and your own SEP-IRA deduction are interrelated, the IRS requires a separate calculation and a new SEP-IRA contribution rate for yourself:

■ First, from your sole proprietorship net profit of $86,000, subtract your self-employment deduction of $6,076, which equals $79,924. The $79,924 is now your net earnings from self-employment.

■ Next, you must use a new contribution percentage rate from the IRS Rate Tables. Your 25% contribution rate is now lowered to 20%.  You can also compute this by dividing .25 by 1.25 which equals .20 or 20%. 

You then multiply your net earnings of $79,924 by .20 to compute your SEP-IRA contribution and tax deduction of $15,985.

You then deduct the $15,985 under Adjusted Gross Income on page 1 of your Individual Federal Income Tax Return.
The additional 401K salary deferral feature though could have been as much as $17,000 for the year 2012 ($22,500 if age 50).  This would increase your total retirement plan deduction for 2012 to $32,985, instead of $15,985.
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Simplified Employee Pension SEP-IRA

Self-Employed SEP-IRA Pension Plan

A Simplified Employee Pension Plan is a less complex plan for your small business.
The key point is that the IRS rules require that you must make the contributions for all of the employees including yourself. 

If you don't want to make contributions for employees, then a SEP-IRA is not the retirement plan for your business.  However, if the business does not have any employees except yourself, you can still set up a SEP-IRA and contribute only for yourself.
If you had no employees except yourself, the SEP-IRA retirement plan would have given you a substantial tax deduction of $15,985 in the above example. 

However, if you had established a Profit Sharing Plan with a 401k feature, your deduction could have been much greater.  The Profit Sharing Plan would have allowed you the same deduction of $15,985. 
Simplified Employee Pension Plan (SEP-IRA)
SEP-IRA Contribution Limits
If you are a sole proprietor, how much can you contribute to a SEP-IRA for yourself.
For instance, assume that your W-2 compensation is $86,000 and you have chosen the maximum contribution of 25%. Your SEP-IRA contribution would be $21,500 and you would be allowed a $21,500 tax deduction on your corporation federal income tax return.
If your small business is a corporation, it is easy to compute the amount that you can contribute to your own SEP-IRA.  You simply multiply your W-2 compensation by the percentage contribution that you have selected. 
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However, the IRS does not consider the $86,000 to be your net earnings upon which your SEP-IRA contribution is calculated.

The IRS requires you to deduct from the $86,000 both the deduction for one-half of the self-employment tax (social security tax) and for your own SEP-IRA deduction.
Now, if you are self-employed, the SEP-IRA calculation becomes a little tricky.  We will assume that your sole proprietorship net profit is also $86,000 before any SEP-IRA deduction. 
The amount you contribute is not considered to be additional taxable income for the employee.

Therefore, you do not show the SEP-IRA contribution as income on the employee's Form W-2.

The tax benefit is that your business is allowed an income tax deduction for the total contributions to each SEP-IRA, including the contribution to your own SEP-IRA. 
You can also view your employee contribution as an added employee benefit that may help to build employee loyalty and attract better employees. This in turn will help make your business better and thus more profitable.
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