Self Employed? Discover the SEP-IRA.

The SEP-IRA is a terrific accumulation tool for workers who are self-employed, have a family business, or who have earnings as a 1099 Independent Contractor. SEP stands for Simplified Employee Pension, but the account functions similar to a Traditional IRA. Money is contributed on a pre-tax basis, and then withdrawals in retirement are taxable. Distributions taken before age 59 1/2 may be subject to a 10% penalty.

I wish more self-employed people knew about the SEP-IRA because it has a number of terrific advantages over a Traditional IRA.

  • There are no income restrictions on a SEP-IRA.
  • You can contribute up to $53,000 for 2016, provided your net income exceeds $265,000. With a Traditional IRA, you can only contribute $5,500. (Yes, that is a $53,000 tax deduction, regardless of your income level.)
  • You can fund a SEP and may still be eligible to fund other retirement accounts. For example, let’s say you have two jobs, one as a W-2 employee and one as a 1099 Independent Contractor. You could contribute $18,000 to a 401(k) at the first job, and also fund a SEP for the Independent Contractor work.
  • You can contribute to a SEP and still do a Roth or Traditional IRA, if eligible. In fact, by contributing to the SEP, you may lower your AGI and help maintain your eligiblity for a different IRA, if your income was just slightly over the allowable levels.
  • The SEP-IRA is the only IRA that can be funded after April 15. If you file an extension with the IRS, you have until October 15 (or September 15 if a corporation) to fund a SEP for the previous year. With other IRAs, the contribution deadline remains in April, regardless of when you actually file your taxes.
  • You can convert a SEP to a Roth IRA. This is beyond the scope of this article, but if you are interested in this idea, contact me for details.

The contribution to a SEP is made by the employer, rather than the employee. If you are self-employed as a 1099 Independent Contractor or a sole proprietor, then “you” are considered both the employer and employee. However, if you own a company, for example, a C-Corporation, then the company would make the contribution and claim the deduction on the company’s tax return.

The biggest drawback to the SEP is that your contribution amount depends on your income. The employer can contribute up to 25% of the employee’s income. For example, if the employee salary is $80,000, the employer could contribute up to $20,000 to the SEP each year. For someone who is the self-employed, it may be easier to think of this as 20% of your net income. In other words, if you made $100,000, you could contribute $20,000 to the SEP and leave yourself with $80,000 in taxable income.

Either way, it is very difficult to calculate your SEP contribution until you or your CPA prepares your tax return, since tax-deductible expenses will reduce your net income. For this reason, most SEP participants wait to fund their account until tax time, which is a decided disadvantage compared to other accounts where you can dollar cost average throughout the year. I’ve only had one client who funded his SEP early each year, and that was because his income was so far over the $265,000 level that he knew he was eligible for a maximum contribution by mid-year.

Since a SEP is a company sponsored plan, employers must fund a SEP at the same level for all W-2 employees. If you contribute 16% to your own account, you would have to contribute 16% for all eligible employees. The percentage can vary from year to year, as desired, but the employer cannot discriminate between employees on the level of funding. Employee accounts are 100% vested at all times. Note that an employer is not required to fund a SEP for 1099 Independent Contractors you pay.

While SEPs were designed for any size business, in practice, very few firms with multiple employees use a SEP, with the occasional exception of a family business where all the employees are family. Instead, SEPs are most popular with sole proprietors and free-lancers.

Not sure which IRA or retirement plan is right for you? Call me, I can help you make sure you are taking advantage of every opportunity to save money on a pre-tax basis.