SEP-IRA Basics for the Self-Employed

Simplified Employee Pensions, or SEP-IRAs, are a retirement account available to both small business employers and employees under certain requirements. Although I’m sure they are covered more thoroughly elsewhere, I wanted to jot some notes down focusing on the self-employed, that is, you are both the only employer and employee all rolled into one. Beware, during my research I found a lot of outdated and thus inaccurate information online.

Who’s Eligible?
Anyone who has any amount of self-employment income, even if you already have a retirement plan with your other job.

Deadline to open and fund?
The same as your tax filing deadline, including any extensions. Without extensions, that’s good ole’ April 15th.

What the maximum contribution amount?
For 2005, the maximum contribution is 25% of the employee’s ‘eligible compensation’, up to $42,000. But for self-employed people, the IRS’s definition of ‘eligible compensation’ is a bit funky. There’s a whole worksheet to figure it out in IRS Publication 560. It ends up being a max of 20% of your net profit from your Schedule C minus the deductions for self-employment tax. Again, the ceiling is $42,000 for 2005.

What the minimum contribution amount?
Zip. Zero. You can contribute a ton this year, and none the next year. Very flexible.

What are the Tax-advantages?
The vehicle for SEP-IRAs is basically a Traditional IRA. Thus, you can deduct your entire SEP-IRA contribution on your taxes. Also, future earnings grow tax-deferred. Of course, this means that distributions will also be taxed upon withdrawal, and early withdrawals have additional penalties.

How to do I set one up?
Much like setting up a Traditional IRA, most financial institutions like Vanguard, Ameritrade, or Fidelity will set one up for you with minimal or no fees. There is also minimal paperwork required, with no annual reports to file.

What if I already have a 401(k) at my other job or Roth IRA?
Contributions to a SEP-IRA do not affect either your eligibility for either of those.

For more information, I didn’t find any one awesome resource, but I did find that most brokerage houses like Fidelity have pretty good updated information. As always, the IRS is the definitive source, although it’s like reading Shakespeare at times. The most pertinent ones are Pubs 560 and 590.

Comments

  1. Jonathan,

    Thanks for your research. I’ve been looking into this as well. Two related questions pop to mind:

    1) Do you still pay self-employment tax on money deposited into a SEP-IRA or do you defer that tax until you take distributions in rertirement?

    2) If you’re deferring the self-employment tax until retirement, what are the implications? Aren’t you effectively speculating on future self-employment tax rates AND your future income tax bracket? (i.e. Are you taking a risk that social security and medicare taxes will be higher in retirement than they are now?) Given social security insolvency, I tend to think those taxes might increase.

    Anybody have any thoughts on the above?

  2. off topic, but did you hear about prosper.com?

  3. Joshua – I’m pretty sure you pay the SE tax now, just like you pay all your payroll taxes like FICA now, even if you have a 401(k) or Traditional IRA.

    Micah – No, very interesting. I’ll have to check that out some more later.

  4. Jonathan — Interesting. So if you pay the SE tax now, the true benefit to a SEP-IRA is that you can “extend” the amount of money you can contribute to IRA-type accounts, correct? ($4000 in Roth/Traditional IRA + 25% of eligible SE income in SEP-IRA).

    Since I’ll be hard pressed to max out my Roth/Traditional IRA $4,000 limit, I can’t see any other special benefits a SEP-IRA offers.

    Thanks for your insight.

  5. as always…a great write-up. We chose an individual 401(k) for lala’s (freelance) income because the limit was 20% of net profits *on top of* the current 401(k) limit (last year was 14k etc). She didnt quite make it to $14k, but did get more than $10k in there which was more than she would have been able to with a SEP in our case.

    Oddly, the Fidelity individual 401(k) appears as a “profit-sharing keough” in their statements and web interface. The only thing that bums me out about it is that we have to send paper checks to contribute (?) and cannot use their online money transfer system instead. But that is a very small bummer ;)

  6. Artie McDonald says:

    When considering contribution limits to the SEP-IRA and 401k you have to keep in mind there are two limits that are in play and need to be kept track of. The $14,000 limit that most people are familiar with ($15k in 2006) is the “employees elected salary reduction limit.” This $14k limit applies across all employer sponsored retirement accounts, including 401ks, simple and SEP IRAs. However, the contribution you make to your SEP IRA as a self employed individual is considered an “employer contribution” and hence not subject to the $14k limit. However, it is a contribution to the retirement plan which is subject to the 25% (or $41,000) total contribution test, regardless of source. The total amount that can be contributed to all employer sponsored retirement accounts cannot in aggregate exceed 25% of the individual?s income, or $41,000. This includes SEP-IRA, Simples, 401ks, Keoghs, etc, and factors in all contributions you make (pre and post tax), your employer contributions (including self employed individuals SEP contributions), profit sharing, company match, etc.. Note that this does not include ROTH or traditional IRAs or your contributions to those accounts; they have separate contribution rules and are not intermixed.

    Since the SEP contributions are considered ?employer contributions on the employee?s behalf?, there are rules requiring that you must contribute in equal percentages to any and all qualified employees. This of course is only ?yourself? for a self employed person. Your employees, if any, would also be allowed to make their own contributions to the SEP IRA via salary reductions, up to 14k pre tax, and no more than 25% in aggregate with your contributions capped at $41k.

  7. Does “any amount of self-employment income” include money from odd jobs like baby-sitting, leaf-raking and snow shoveling . . . if the person who hired you w-2′d you for these things?

  8. Yeah, I’ll have to do that 401k vs. SEP IRA thing soon. First I must finish these oh-so-fun taxes.

    Anon – A W-2 means the person who hired you is the employer, not you. Thus, that is not self-employment income.

    If they hired you as an ‘independent contractor’ and paid you via a 1099-MISC, then that would be self-employment income.

  9. Artie McDonald says:

    BTW, other interesting tidbits about why there are some weird calculations (IE why you can only contribute 20% to your SEP and not 25%, or why there?s a 92.35% multiplier on Schedule SE) to determine income limits and deductions for self employment taxes. These are mostly done to normalize the taxation of the business profit to be equivalent to someone who received those earnings as wages and to make the taxation of the two amounts to be fair. The net profit amount carried over from schedule C to the 1040 actually includes amounts that are not subject to federal taxation since they include monies that will normally not be taxed to a regular employee (because they never see the money in their checks in the first place).

    For example, the reason you get to deduct 50% of your self employment taxes paid is because a regular employee only pays federal income taxes on the employee?s share of the social security and the medicare taxes. The employer?s share of those same taxes are not taxable income to the employee. Therefore, a self employed employee excludes the employers share from their total income for federal tax purposes.

    If a contribution to the SEP is elected by the self employed person, that amount is also deductible because that contribution is an employer?s contribution and is deposited on a pre tax basis. This is similar to a typical employee who receives a company match or a profit sharing contribution to their 401k. Therefore, the SE person gets to exclude that contribution from their income as well.

    The 92.35% multiplier on Schedule SE is to exclude the social security and medicare taxes on the portion of the SE income that ultimately will be paid out as the employer?s share of the social security and medicare taxes. Essentially all employees (yourself included) really only pay taxes on 92.35% of our salary (if the income is less than $90k. We just don?t see 7.65% of our salary that our employers pay the government on our behalf, and in turn are not subject to pay federal, or SS taxes on those amounts. This adjustment makes the SSI tax fair to the SE individual.

    And finally, why the SE employee can only contribute 20% of the net profit to the SEP instead of the 25%… Well the reason is, the total you can make is 25% of your actual earnings, so you must reduce the net profit by any employer (self) contributions or employer-paid taxes since they are excluded from the individual?s income, and figure the 25% based on the reduced (fully subject to federal taxation) amount. When all is said and done, if the employer chooses to contributed 25% of their to their employee?s SEP IRAs, the employers personal share is 20% of the total net profit (but when you redo the math it will end up being 25% of the total income subject to federal taxes the SE person had). If the employer wanted to contribute 15% to all the employees, then their share is only 13.05% of the net profit number (but still 15% of their real income).

  10. Great info Artie. You must be a CPA.

    Your two posts are the best information I’ve seen on SEP’s in a few years.

    I’ve used this calculator for a couple of years now to easity estimate my SEP contribution:

    link

    1) I think SEP’s are such a great deal if you can afford to max it out.

    2) I’ve always thought a great and easy way to solve the country’s impending Social Security problem is to elminate or accelerate the $90,000 base on social security tax (6.2% of wages less than 90,000 for 2005).

    Wes

  11. Artie…great info (and clear too!) thanks!

  12. Jonathan,

    Not sure why you opted for the SEP IRA over the Solo 401(k). The 401(k) seems to have clear advantages over the SEP IRA and I have heard great things about Fidelity’s offering. Unless it was a result of missing calendar year deadline to open the 401(k)?

  13. Yep, missed the deadline. Haven’t decided what to do for 2006. I am actually waiting for more providers for Roth 401(k)s to jump in the game.

  14. I am a little confused on the self-employed 401K. I have a man who is a sole-proprietor. he contributes 14,000 into a self-employed 401K. His net profit on schedule C shows $35,000. Can I take 25% of $35,000, which would be $8750 and make that employer contribution although he is not employed by his own company since he is a schedule C no paycheck. Then deduct that $8750 from his schedule C as an expense on line 19, profit sharing plans? This making his schedule C net income 26250? Or is the “employer” contribution only for self-employed whom get actual paychecks? Or the “employer” contribution not deductible on the schedule C just on line 32 on the 1040?

  15. Darlene says:

    I am a little confused on the self-employed 401K. I have a man who is a sole-proprietor. he contributes 14,000 into a self-employed 401K. His net profit on schedule C shows $35,000. Can I take 25% of $35,000, which would be $8750 and make that employer contribution although he is not employed by his own company since he is a schedule C no paycheck. Then deduct that $8750 from his schedule C as an expense on line 19, profit sharing plans? This making his schedule C net income 26250? Or is the “employer” contribution only for self-employed whom get actual paychecks? Or the “employer” contribution not deductible on the schedule C just on line 32 on the 1040?

  16. NKaufman says:

    It is my understanding that as a sole proprietor, he cannot enter any amount on Sch C. He has to enter both employee deferrals and employer contribution on 1040

  17. “2) I’ve always thought a great and easy way to solve the country’s impending Social Security problem is to elminate or accelerate the $90,000 base on social security tax (6.2% of wages less than 90,000 for 2005).”

    Wes,

    If you haven’t noticed, they’ve already raised the cap 40 times, and that hasn’t ever helped. Even if you eliminate the cap completely, that doesn’t even fix half of the problem and it delays insolvency by only 6 years.

    The solution is to raise the retirement age. People in 1940 spent 16% of their lives in retirement. Today it’s about 22%. The social security system (and the economy) just can’t handle people who work for 40 years and are retired for 20 years.

    Why do you feel our government and fellow citizens have the right to demand another 6.2% of ALL INCOME from those who are successful? For some people, this amounts hundreds of thousands of dollars.

    Why should some be required to pay millions over their working lives in order to get back a miniscule benefit? So that everyone else can have 20 years of retirement spent playing the slots in Vegas? I don’t think so!

  18. “Why do you feel our government and fellow citizens have the right to demand another 6.2% of ALL INCOME from those who are successful? For some people, this amounts hundreds of thousands of dollars”

    If the successful “bail out of the economy,” then there’s no economy left. I think it’s an ethical thing because, if the “sucessful” indeed “bail,” then the “less successfull” will probably use force and other means to survive.

  19. I have an employee who started working for me 2 years and 10 months ago. She will be a 3 year employee as of October 27. Am I correct in believing that for the 2006 SEP contribution I need to make by Sept 15, she would not be eligible as she has not worked for me for 3 of the last 5 years?

    Additionally, if she were to leave me in the spring, before I would make the 2007 year contribution, would I have to make the payment for her and set up an account for her?

    Thanks for your advice.

  20. I work for a large corporation and contribute to their 401(k). I also have business income (through an LLC) and would qualify to create a retirement plan.

    Do I save more (7.65%) by establishing a self-employed retirement plan rather than from my paycheck (W2)? It’s not clear to me whether the contributions my business would reduce my net income and that I would then avoid the 7.65% medicare and social security tax.

  21. I Live in UK. I am going to start a internet shop but I can’t invest for that business. my friend agreed to invest fully in this business but she want share the netprofit. could anyone advise me how to share the netprofit between me and my friend?
    Note: My friend is going to invest only but I am going to manage everythink because I am IT & accounting qualified person

  22. Go Go Suppliers says:

    I am single Member LLC filing as S Corp.
    I am paying myself a salary and making monthly Federal Payroll Tax Payments.
    I am making Quaterly Distributions to myself from the remaining Profits the S Corp makes, retaining some money into the Business.

    Question 1:
    Am I required to file Estimated Tax form for myself.(Form 1040-ES)

    Question 2:
    In Addition to FORM 1040-ES am I required to file Estimated Tax form for the S Corp too ( FORM 1120-W)

    My Understanding is that S CORP is a pass through entity so Either Me ( Single Owner) or the Coorp should file Estimated Tax form. Is my understanding correct.

    Please comment

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  1. [...] way to spend a Saturday! Ugh. At least now I’ve figured out that I can contribute $2,500 to my 2005 SEP-IRA. I plan to open one up at Vanguard by the April 17th deadline and then merge it with the rest of my [...]

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