I recently did some in-depth research on SEP IRAs, SIMPLE IRAs, and Solo 401Ks for personal use for my side self-employment income and wanted to cover the primary questions I had and answers I found, for your benefit (and to help myself remember, if I’m being totally honest).
If you have self-employment income (or plan/hope to at some point), this should be of interest. If you want to work for “the man” for the rest of your days, you can probably tune out.
This post, an overview of SEP IRA basics, will be part 1 of a multi-part series. I’ll wrap it up with a comparison between retirement plans for self-employment income.
What is an SEP IRA?
SEP does not stand for “self-employed plan” or “self-employment plan” as one might expect. In fact, it stands for “Simplified Employee Pension”.
The cool kids pronounce it as one word – “sep”, versus “S-E-P”, by the way.
If you are looking into a SEP IRA for the purposes of directing self-employment income to retirement savings – don’t let the “employee” in the name deter you. Business owners can create an SEP IRA offering for employees (I won’t cover the particulars in this post, so you’ll want to consult other resources), but you can also create one for yourself.
At its core, SEP IRAs are VERY similar to Traditional IRAs. Both are pre-tax investment vehicles that allow you to deduct contributions from your taxable income to save for retirement.
The main difference between the two is who can contribute and how much you can contribute.
What are the Qualifications to Create & Contribute to an SEP IRA?
If you have self-employment income, you can establish and contribute to a SEP IRA with a few qualifications:
Must be age 21 or older
Must have worked for the employer (yourself) in at least 3 of the last 5 years
Must have received at least $550 in compensation from the employer (self-employment income)
Self-employment income for the purpose of this deduction means net profits from a Schedule C or Schedule F, self-employed income from a partnership, or wages as a shareholder-employee in an S-corporation. You do not have to have a registered LLC or maintain other incorporated status to be eligible for a SEP.
Can you Contribute to Both a 401K and a SEP IRA?
If you have an employer, you can contribute to both your employer’s 401K and make contributions to your own SEP IRA (as your own employer) simultaneously. Pretty sweet.
Can SEP IRAs be Roth SEP IRAs?
No. At this time, SEP IRAs are only pre-tax in nature. Given the recent popularity of Roth’s and the addition of Roth IRA and Roth 401K accounts as investment vehicles in recent years, I would speculate that might change. But at this time, pre-tax only.
Can you Roll SEP IRAs Into a Roth IRA?
Yes, you can roll an SEP IRA in to a Roth IRA, if you’d like. Be aware, as with all traditional-to-Roth rollovers, that any amount you roll over is considered taxable income in the year that you roll it over.
SEP IRA Contribution Deadlines
And as with those IRAs, if a contribution comes between January 1st and the tax deadline, you can characterize it for the previous or the present calendar year. This (very conveniently) allows you to lower your tax liability for the prior calendar year at the time you are actually doing your taxes. Note that contributions for a calendar year must be made prior to filing your taxes for that year.
SEP IRA Contribution Limits
To recap, the maximum IRA contributions for Traditional and Roth IRAs are capped at $6,000 in 2019/2020 (with a catch-up contribution of an additional $1,000 if you are age 50 and above). There are also income phaseout restrictions for each, at which point your ability to contribute (or deduct your contribution) is phased out to $0.
This is where SEP IRAs deviate substantially from Traditional and Roth IRAs and can be vastly superior, if you have self-employment income.
The maximum SEP IRA contribution for each employee can go up to the lesser of:
- 25% of compensation, or
- $56,000 for 2019, $57,000 for 2020
However, special rules apply for self-employed individuals which limits the maximum deductible contribution that they can make.
Should you Contribute to an SEP IRA as an Employer or an Individual?
When you make an SEP IRA contribution, you may have the option of contributing to an SEP IRA as an employer or individual. If you have self-employment income, you can contribute as your own “employer” and should do that first. You could also contribute as an “individual”, but you’ll want to make sure you stay under the Traditional IRA income limits for eligible tax deductions.
Calculating the Self-Employed Maximum Deductible SEP IRA Contribution:
The calculation for how much you can contribute to your own SEP IRA as an “employer” is not as easy as taking the percentage (up to a max of 25%) and multiplying by your net income. Why? Because your SEP contribution must first be deducted from your net earnings.
To figure out how much you can deduct:
- Start with your net profit (income minus expenses)
- Subtract one-half of your self-employment tax (which is a deduction)
- Subtract your SEP contribution (also a deduction)
Wait, how can you calculate the SEP contribution if you don’t yet know the percentage rate you can contribute?
This is where the IRS SEP rate table for self-employed contributions can help. To calculate the rate yourself, here is an example, assuming a plan contribution rate of 25%:
- Put your plan contribution rate (as a decimal): 0.25
- Add 1: 1 + plan contribution rate (in this example, 0.25) = 1.25
- Take #1 and divide by #2: (0.25/1.25) = 0.2
To get the max deductible contribution, multiply the result in step #3 (the same as the percentages in the rate table) by your net self-employment income, before SEP deduction.
For example, the max deductible contribution for $100,000 would equate to $100,000 x 0.2 = $20,000. This equates to 25% of the post-deduction income of $80,000.
Go ahead and re-read that a few times, if you’d like. 😉
SEP IRA Contribution Calculators
If you want to double-check your math, here are a few SEP IRA contribution calculators that can lend a hand:
- Vanguard’s retirement plan contribution calculator
- Bankrate’s self-employment plan calculator
- CalcXML retirement plan calculator
Where Can you Open a SEP IRA?
SEP IRAs are fairly popular and each of the discount brokers highlighted in my “how to start an online broker account” article have an SEP IRA option. Make sure to research minimum balance requirements and any associated fees, including account maintenance or inactivity fees before creating your account.
SEP plans are incredibly easy to set up and require no more paperwork or filing requirements than other IRAs.
Other SEP IRA Resources:
If you have any questions, definitely consult with a tax professional and/or a brokerage firm.
Outside of the SEP IRA resources highlighted earlier, you should also check out the following articles:
- SEP Plan FAQ’s
- IRS Publication 560, Retirement Plans for Small Business (this is the big one)
- IRS Publication 4333
- IRS Publication 4285, SEP Checklist