If you’re self-employed and want to start saving for your retirement, you may wonder what plans are available to you. One excellent option you have is opening up a SEP-IRA retirement plan. SEP IRAs require a simple set-up process, and their maintenance is also easy. SEP-IRAs also don’t have any reporting requirements, and their contribution limits can be adjusted. Most self-employed individuals enjoy the flexibility of having a SEP-IRA for their retirement savings. So, if you’re self-employed and considering a SEP-IRA, we’ve got some vital information to share with you about the basics of these accounts and their contribution limits.
What is a SEP-IRA?
A SEP-IRA works as a retirement account that benefits both business owners and self-employed people (which usually also means you’re a business owner). Business owners can use a SEP-IRA to save for their personal retirement or offer it as a retirement option to their employees. Self-employed people also benefit from having a SEP-IRA account since they can use it to contribute to their retirement as their “own” employer. A SEP-IRA has the benefit of simplicity for business owners and the self-employed since it can be created and maintained without much paperwork. Another advantage of these retirement plans is that there are no yearly tax filing requirements.
Once you open a SEP-IRA account, you’ll be able to contribute income that is tax-deductible to your retirement. That means you can enhance your retirement earnings as you make your tax-deferred contributions regularly. You won’t be taxed on your initial contribution or the gains made on your account until you decide to withdraw from your SEP-IRA once you’ve retired. Another benefit of having a SEP-IRA is that you’ll get plenty of flexibility when funding your account every year. So, if you’re self-employed and your income tends to fluctuate, this is a major advantage. If you wind up having an amazing year while you are self-employed, you can invest as much as the SEP-IRA contribution limit. On the flip side, if you have a challenging year and money is tight, you aren’t required to contribute anything if you don’t have the income.
SEP-IRA contributions are similar to traditional IRA assets in the legal sense. So, that means a SEP-IRA follows many of the same regulations that apply to a traditional IRA.
How is a SEP IRA like a Traditional IRA?
Many of the same rules apply to SEP-IRAs, so this retirement option resembles a traditional IRA. For example, you can only withdraw from the account once you reach the age of fifty-nine and a half if you want to avoid incurring a ten percent penalty, just like a traditional or Roth IRA.
Once you reach the age of seventy-two, you’ll need to take out the required minimum distributions (RMDs) from your SEP-IRA, which is also similar to a traditional or Roth IRA. Once you turn seventy-two, you have until April 1st of the following year to receive your first required minimum distribution. After you’ve taken the first minimum distribution, you have to take out your other RMDs by December 31st of every year. That rule still applies even if you took your initial RMD out on April 1st of the same year.
With a SEP-IRA, employers are required to make retirement contributions. Thus, a SEP-IRA won’t allow you to make any catch-up contributions if you are over the age of fifty, which is unlike a traditional or Roth IRA account.
One benefit of pursuing a SEP IRA is its ease of use and availability. Several financial institutions offer this type of retirement plan and require a simple process to create the account. If you decide you want to set-up a SEP IRA, you’ll need to submit an application with an investment company or a brokerage firm. Once you’ve created the account, you’ll be able to formulate an investment plan and portfolio that has several options in investments. Some of the choices you’ll have include exchange-traded funds, mutual funds, and stocks.
Depending on the financial institution that you select for your SEP IRA, you typically won’t have to pay a set-up fee. Also, most of the time, there are no yearly maintenance fees associated with a SEP IRA.
Who Should Get a SEP-IRA?
SEP-IRAs are great retirement savings options for small business owners and those that are self-employed. SEP IRAs differ from traditional and Roth IRAs for individuals because SEP-IRAs do not have a set contribution deadline. For traditional and Roth IRAs, the yearly deadline is usually on April 15th. SEP IRAs, however, have a different deadline. With a SEP-IRA, the deadline for making the account and contributing to it is the same as the filing deadline for the employer’s tax return.
People opt for SEP-IRA accounts for various reasons. One benefit to a SEP IRA account is how easy the plan is to manage. Also, many people enjoy the flexibility they get with their yearly contributions depending on how their self-employment ventures are treating them that year.
For instance, if a self-employed construction worker decides to open a SEP IRA account, the cyclical nature of the worker’s profession could benefit from the structure of this retirement plan. During high-earning years, the worker can contribute more to the retirement account. However, when the worker’s earnings dip, there’s still flexibility. With a self-directed SEP, the worker decides when and what to invest in when contributing to the account. Even when the self-employed worker cannot afford to make contributions because of a low-earning year, he still owns the account and has total control.
What are the SEP-IRA Contribution Limits?
One of the major advantages of SEP-IRA accounts is their tax-deferred status. So, you’ll get immediate, up-front tax breaks with the bonus of tax-deferred savings. That means you won’t need to worry about paying any taxes on the money in your SEP IRA until you retire and withdraw money from the account. Many self-employed individuals also enjoy the increased contribution limit offered by a SEP IRA.
Another benefit of opening up a SEP-IRA account is that the employer’s contributions do not affect how much you contribute to a different IRA account, like a Roth IRA or a traditional IRA. Still, you may not qualify for a tax deduction on contributions to your traditional IRA if you also have a SEP IRA account.
By comparison, a SEP-IRA’s contribution limits are much more substantial than a traditional or Roth IRA. A SEP-IRA’s 2021 contribution limit is equal to a quarter of the employee’s yearly compensation.
Thus, a SEP IRA would have the employer making the contributions, which can still be the self-employed individual. If you are your “own” employer, you can contribute to your SEP-IRA as your employer, and that should be your first step. If you are a self-employed business owner with employees, then your employees’ earnings impact the amount put into their accounts. Every contribution made to your participating employees with a SEP-IRA has to use the same percentage amount as the one you applied to your personal SEP-IRA. For instance, if you are a self-employed business owner with employees and make a 25% contribution to your SEP-IRA as the company owner, you’d also have to make a 25% contribution to any other employees who utilize this plan and work for your business.
Not all of your employees may qualify for your company’s SEP-IRA plan. Individuals that qualify for a SEP-IRA must be twenty-one years old, have been employed by your business for at least three out of the previous five years, and have been paid more than $650 in 2021 from your business. Still, if you want to, you can use less limiting eligibility requirements on your employees, like lowering the age to eighteen. However, you cannot legally impose more restrictions on your qualifying employees.
Some self-employed people decide to use a self-directed SEP-IRA. One excellent advantage of a self-directed SEP-IRA is that you can pick from a bevy of different investment options. With a self-directed SEP-IRA, you wind up with the same limitations and regulations as you would with a traditional SEP, but you can invest in different assets. With the higher contribution limit, you can put your money in other things like real estate if you’d like. Thus, you may be able to contribute as much as $58,000 in 2021 to this type of IRA, which can help you save for retirement quickly.
Suppose your business also offers another contribution plan beyond your SEP account, like a 401k plan. In that case, your yearly contributions in 2021 for yourself and to each plan cannot go above 25% of your yearly earnings from your self-employment income, which can be up to $58,000.
You’ll need to know other rules as a self-employed person with a SEP-IRA because there are some limits to the maximum deductible contributions you’ll be permitted to make. We’ll cover those in more detail below.
Calculating the SEP-IRA Maximum Deductible as a Self-Employed Worker
You might be wondering how you can calculate your SEP contribution if you don’t know what the contribution percentage rate is. Luckily, you can use the IRS’s SEP rate table, which breaks down contributions for the self-employed.
If you’d rather calculate the rate on your own, we’ll give you an example of how you can do that below. First, let’s assume that your plan’s contribution rate is 25%.
- First, enter your plan’s contribution rate as a decimal rather than a percentage. For instance, 25% would be entered as 0.25.
- Next, you need to add 1 to your plan’s contribution rate. So, using our example, we’d have 1.25 after adding 1 to 0.25.
- We take the first number, 0.25, and divide it by the second number, 1.25. Again using our example, 0.25/1.25 would equal 0.2.
Your maximum deductible contribution can be obtained by multiplying the result, which was 0.2 in our example, by your net income before you took the SEP deduction. Using our example again, let’s say that your net income before your SEP deduction was $100,000. So, you’d now multiply the net income of $100,000 by 0.2. So, $100,000 X 0.2 equals $20,000. That number represents 25% of your yearly post-deduction income, which would be $80,000.
If you aren’t comfortable with doing the math, you can use a SEP-IRA contribution calculator, like the one here.
Setting Up Your SEP IRA
If you decide to set-up a SEP IRA account, you’ll need to include all of your eligible workers and complete a formal written agreement using Form 5305-SEP. Every worker that is eligible to participate needs to receive a copy of the form as well. Your business will not be able to adopt the SEP-IRA plan until every qualifying employee receives the form.
SEP-IRAs also give you a last-minute tax savings option, which can decrease your tax bill as a self-employed business owner. You’ll still be required to follow all regulations regarding SEP contribution deadlines if you want to get extra savings when it’s time to do your taxes. The tax deadline for most corporations and self-employed people is usually April 15th. If you request an extension on your taxes, then your tax filing deadline may fall on October 15th instead. If you want to use your SEP-IRA for your taxes this year, you’ll need to have the account set-up before your corporation’s tax filing deadline passes.
Remember, self-directed SEP-IRA distributions operate just like other tax-deferred IRA accounts. Thus, your distributions work like regular income and will be taxed once you withdraw from the account. If you withdraw before you are the age of fifty-nine and a half, you’ll incur early withdrawal penalties as well as taxes. Still, SEP-IRAs are great retirement plans for self-employed business owners that want to ensure they have plenty of money in the future.
Once you are ready to set-up your SEP IRA, you’ll be well on your way to investing in your future and paving the pathway toward retirement. Ensuring that you’ll be well provided for after you retire is certainly one of the best investments you’ll ever make.
If you’re looking for a financial advisor who can help guide through the finance aspects of your small business then you’re at the right place. At Client Focused Advisors we specialize in working with Small Business owners to help set them up for financial success and keep their business processes running smoothly. Contact us today for more info!