To fix an excess SEP contribution, have the SEP-IRA custodian distribute the overage plus any earnings it produced and return that money to the employer who made the deposit. Do it before the employer’s tax filing deadline, including extensions, and the 6% annual excise tax on the employee goes away. For 2026, a SEP contribution is capped at the lesser of 25% of the employee’s compensation or $72,000; anything above that is an excess that needs correcting.
Confirm the Contribution Is Actually Excess
Two limits apply to every SEP contribution, and the lower one controls. The percentage limit is 25% of the employee’s compensation. The dollar ceiling for 2026 is $72,000. If 25% of pay works out to $50,000, that is the cap for that person. If 25% works out to $90,000, the $72,000 ceiling takes over.
Only the first $360,000 of an employee’s compensation counts in the calculation. Someone earning $400,000 has their contribution figured on $360,000, which gives a percentage-based maximum of $90,000, then trimmed to the $72,000 ceiling.
Self-employed people run a different calculation. Because the SEP deduction itself reduces net earnings, the effective rate is roughly 20% of net self-employment income rather than 25%. That adjusted rate accounts for both the SEP deduction and the deduction for half of self-employment tax. Miscalculating this is a common source of excess contributions for sole proprietors.
Calculate the Excess and Its Earnings
Do the basic subtraction first: actual contribution minus maximum allowable contribution. Run it separately for each participant.
Principal alone is not enough. The IRS also wants the net investment earnings (or losses) attributable to the excess, measured from the deposit date through the distribution date. If you cannot pull actual investment results, a reasonable rate of interest is acceptable, such as the rate used by the Department of Labor’s Voluntary Fiduciary Correction Program Online Calculator.
The cleanest method is pro-rata. Say the excess was $5,000 and the SEP-IRA balance at the time of contribution was $50,000. The excess is 10% of the account, so 10% of the net gain or loss over the period is attributable to it. If the account earned $2,000 during the window, $200 belongs to the excess and the corrective distribution is $5,200. If the account lost money, the distribution comes in below the $5,000 principal. Document the math either way; the custodian and the IRS both want to see it.
Distribute the Excess and Return It to the Employer
Contact the SEP-IRA custodian, explain that you are making a corrective distribution of an excess contribution, and request that the calculated amount (principal plus attributable earnings) be paid back to the employer that made the contribution. The custodian processes it as a corrective distribution and issues a Form 1099-R to the employee.
Per IRS guidance, the distributed principal is not included in the employee’s income and is reported on Form 1099-R with a taxable amount of zero. The employee never received the excess as compensation; the money is going back to the employer.
Timing is the whole game. If the excess leaves the account before the employer’s tax filing deadline, including extensions, the 6% annual excise tax on the employee is avoided entirely. For a calendar-year business on extension, that typically means an October deadline. Miss it and the penalties start stacking.
Fix the Deduction on the Tax Return
The employer cannot deduct the excess portion. If the full contribution was already claimed on the business return, file an amended return to strip the excess out of the deduction. The IRS is direct on this: the plan sponsor is not entitled to a deduction for excess contributions, whatever correction method is used.
For self-employed filers, the excess deduction sits on Schedule 1 of Form 1040. File a Form 1040X to remove it and recalculate the tax owed. Filing sooner keeps interest on the underpayment low.
Penalties If You Don’t Correct in Time
Two separate excise taxes can hit, and they hit different people.
A 6% excise tax under IRC §4973 falls on the employee for each year the excess stays in the SEP-IRA. The employee reports and pays it on Form 5329, filed with the personal return. It applies every year until the excess is removed or absorbed by future contribution room. A $10,000 excess left in place costs the employee $600 per year, indefinitely.
A 10% excise tax under IRC §4972 falls on the employer for nondeductible contributions. Because the excess is nondeductible, it triggers this tax. The employer reports and pays it on Form 5330.
Early Distribution Tax on the Earnings
The attributable earnings paid out with the correction are generally taxable to the employee as ordinary income in the year of distribution. For employees under 59½, the 10% early distribution penalty does not apply to the returned principal, but it does apply to the earnings. A 40-year-old with $1,500 in attributable earnings distributed as part of a correction owes tax on that $1,500 plus an additional $150 penalty.
When to Use the Voluntary Correction Program Instead
A second path lets the excess stay in the employee’s SEP-IRA. Under the IRS Voluntary Correction Program, the employer submits an application, and if accepted, the excess remains in the account. In exchange, the employer signs a closing agreement and pays a sanction of at least 10% of the excess amount, not counting earnings. The extra sanction does not apply if the excess is under $100.
VCP is worth the cost when the excess has sat in the account long enough to generate meaningful gains, when distributing would create logistical trouble with the custodian, or when the error is old, structurally complex, or spread across multiple participants and years. A VCP submission goes through Pay.gov and requires Form 8950, a description of the failure, a proposed correction following Revenue Procedure 2021-30, procedural changes to prevent recurrence, and a user fee. For submissions on or after January 1, 2026, the fee runs $2,000 for plans with up to $500,000 in assets, $3,500 up to $10 million, and $4,000 above that.
For a one-time excess caught inside the filing window, the plain distribution-and-return route handles it. Once Form 5329 or Form 5330 comes into play, or the mistake spans years, a tax professional who works in retirement plan compliance earns the fee.