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Self-employed people, small businesses and even workers with a side-hustle may be able to reduce their 2022 tax bill by contributing to a retirement plan known as a Simplified Employee Pension or SEP.
Here’s how it works: The IRS says that if you are self-employed or own a small business you may contribute up to 25% of your salary to a Simplified Employee Pension or SEP. This contribution reduces your taxable income and can be applied to the previous tax year.
A SEP can be established and funded as late as your tax filing deadline, plus extensions. This means you may fund your SEP as late as October 15, if you filed an extension for your tax return.
Contributions for 2022 can be up to 25% of your salary to a maximum dollar amount of $61,000. Even if you worked for someone else and contributed to a 401(k) or other retirement plan, you may still be eligible to contribute to a SEP.
Pop quiz: If your2022 business revenue was $100,000, your business expenses were $20,000, how much can you contribute to your SEP?
$25,000? Wrong! Your SEP contribution is based on your net business income (revenue less expenses).
$20,000? Wrong again! The contribution amount is capped as a % of your net business income including your SEP contribution. So, in this case, $100k - $20k – SEP contribution.
$16,000? Ding, ding, ding! You are correct.
$80,000 is your net business income before the SEP contribution. Technically, the SEP contribution is an employer contribution which makes it a business expense, so you are limited to contributing 25% of the net business income less the SEP contribution. In this example, 25% of $64,000 ($100k - $20k of business expenses less the SEP contribution) or … $16k.
To keep it easy, think of it this way: your SEP contribution can be as much as 20% of your net income after deducting business expenses. In the example above it would be 20% of $80,000. This number also happens to be 25% of your business income less your business expenses less your SEP contribution.
SEP or IRA. For all practical purposes a SEP and an IRA are virtually the same thing. The big differences are that the SEP can only be done by businesses and the self-employed; whereas, the IRA can be done by anyone with earned income.
Another major difference is the contribution amount: the SEP might allow for a larger contribution. SEPs can be funded up to your tax filing deadline including extensions. IRAs can only be funded up to April 15th of the following year.
A good fit for “solopreneurs”. Small businesses are allowed to open and fund SEP retirement plans for their employees. SEP plans are relatively easy to set up with minimal (if any) fees. The big catch, however, is that you must make a contribution for all employees who meet the plan eligibility requirements.
This can make establishing a SEP cost prohibitive for many small employers.
If your business consists of just you or you and your spouse, making contributions for all eligible employees won’t be an issue.
Some classic examples of people who benefit from funding a SEP plan:
Self-employed persons with high income. Most employees are limited to contributing $22,500 plus catch-up contributions to their 401(k). Successful self-employed people can contribute up to $61,000 to their SEP (2022 tax year). This would obviously be a best case scenario, but if you earn $32,500 or more from your business, a SEP might be a good fit since it would allow you to set aside more money than you could in an IRA.
A consultant, college professor, corporate board member or other person with significant side income and no employees. Even if you participated in your 401(k) at work, the IRS allows you to contribute up to 25% of your self-employment income to a SEP on top of your 401(k) contribution.
Small businesses with few employees or high turnover (ideally none that work more than 3 out of 5 years). The requirement that employers must make a contribution for their employees prevents many from establishing SEP plans. A SIMPLE IRA, 401(k) or other type of retirement plan might be a better fit for small businesses with one or more long-term employees.
Like most retirement plans there are pros and cons, rules to follow, and other considerations to be made before establishing and funding a Simplified Employee Pension. For a quick read on the rules, check out the IRS website or click here.
To decide if a SEP makes sense for you, talk to your tax professional or financial advisor. Keep in mind that if you need to establish a SEP for the first time, there will be paperwork and other requirements. The IRS may have an October 15 deadline, but your IRA custodian may need a few business days to set up your account.
To discuss any of the topics in this blog or to learn more about how we can help you Cross The Bridge To A Confident Retirement, please contact me through my web site mikebranch.net, call me directly at 651-379-3935 or email me at mpbranch@focusfinancial.com.