Key Facts to Know About the SEP IRA

The retirement plan for small business owners, and the self-employed (freelance writers included).

Never Heard of a SEP IRA?

The Simplified Employee Pension Individual Retirement Account (SEP IRA) serves as a foundational retirement account for small business owners. The SEP IRA is also a lifesaver retirement account (and tax saver) for those businesses that are sole proprietors; for example, a freelance writer, or dog walker, or Lyft driver. A SEP has the investment flexibility of an IRA coupled with even higher potential savings limits than a 401k, while the funds reduce tax liabilities — it’s kind of a win, win, win.

Setting up a SEP

Fortunately, the SEP IRA is relatively painless to establish. For extra simplicity, I’m going to cover how to do this as a sole proprietor, but I’ll add snippets to help those of you with employees, too.

First, a SEP must be opened and funded by the business’ tax-filing deadline, to include extensions. Those dates will vary based upon the type of business you’ve created.

Second, if you have multiple employees, you must set up a written agreement. The written agreement must include the name of the employer, the requirements for employee participation, the signature of a responsible official, and a definite allocation formula. The IRS has a model SEP plan document: Form 5305-SEP to help guide you.

To open a SEP IRA , you have to establish the account with a custodian. Custodians are institutions such as banks, insurance companies, or other institutions. I used Fidelity, for example, but any of the other brokerage houses will suffice (Vanguard, Charles Schwab, etc.). I called my Fidelity Rep and let him know I wanted to open a SEP IRA. They walked me through the rest of the process to establish and fund the account. If you don’t want to speak to someone over the phone, you could walk into a branch and set up an account with a representative. Or it can all be done online. The choice is yours. That establishes the account.

Eligibility

An employee or self-employed person is eligible for participation if the following conditions are met:

• At least 21 years old
• Worked for the employer for at least 3 out of the last 5 years
• Received compensation of at least $600

You can make the rules more relaxed. You cannot make them more strict (per the IRS guidelines).

How Much Can I Contribute?

For 2019 contributions to a SEP IRA cannot be greater than $56,000 ($55,000 for 2018) or 25% of compensation — whichever is lesser. Your compensation includes salary, bonus, and other income. If you’re a sole proprietor, the contribution is based on your self-employment income. The calculation is a little different, but a good accountant can tell you the amount quickly. In my experience, the percentage hovers around 20–22%.

Caveat : If you have multiple employees, you must provide the same contribution to them that you provide to yourself. That’s why SEP IRAs are usually for smaller businesses.

The Tax Man — Where to Claim the Contribution

• Sole proprietors: claim the contribution on IRS Form 1040
• S-corp: claim the contribution on IRS Form 1120S
• C-corp: claim the contribution on IRS Form 1120A

As you know, IRS rules change frequently. Please check with your accountant to verify the correct form.

Deducting Plan Expenses

A business owner may be eligible to receive a tax credit for expenses incurred in setting up a SEP. So, save your receipts! Furthermore, the business owner may be able to deduct the plan expenses, including contributions made to the plan. This is one of those wins I was talking about.

Putting it All Together: A Really Simple Life Example With Simple Math

You are a self-employed kitten snuggler. Your business is set up as an LLC, but you selected to be taxed as an S-Corp, which is relatively common for single owner businesses (the default is a disregarded entity).

• You’ve done an incredible job snuggling kittens and have a net income of $50,000 before any SEP IRA contribution.
• You wisely paid yourself a salary of $100,000 for your time, energy, and effort — you’re one heck of a snuggler! That amount is included in the above net figure.
• 25% of $100,000 = $25,000. That $25,000 is less than the max $56,000. Therefore, the $25,000 is the maximum allowable amount you can contribute to your SEP. And being the wise saver you are, you decide to contribute the max.
• After subtracting your contribution to the SEP, your business net income is now $25,000. ($50,000(net)-$25,000(contribution) =$25,000(new net))

Depending on your tax bracket, and if you’re married or single, this SEP contribution could save you thousands of dollars on your taxes! That’s more money in your pocket to expand your kitten snuggling business, or maybe take a vacation.

Where Can I Invest All This Money?

The beauty of the SEP IRA is that you can invest the money in quite a few place. Here are a few ideas:

• Stocks
• Bonds
• Mutual Funds
• Index Funds
• REITs

Final Important Items About Your SEP IRA

• The money invested in the SEP grows tax-deferred until you withdraw it in retirement. At that point, the withdrawal is taxed as regular income.
• If you withdraw the money before 59 1/2, you might incur a 10% penalty unless you meet one of several exceptions (disability, for example). Refer to the IRS guidelines for more information.
• There are no loans permitted. Unlike a 401k, you cannot borrow from your SEP IRA.
• A SEP IRA has funding flexibility. If you have a tough year financially, you can choose not to contribute to the plan. But if you have a great year, you can fund the plan with a larger contribution — the amount is always up to you.

Finally

This certainly isn’t an exhaustive study of the SEP IRA, each situation is unique and there are numerous ways to fully leverage your savings and retirement accounts. But I hope this article can give you a decent guideline to help you start a SEP and start saving! And as always, please consult a financial and tax advisor to determine if this is the right plan for you.

If you have any questions, comments, or suggestions please let me know. I’m always looking to improve my articles. Keep the FIRE burning!