SEP IRA: Big Tax Savings for the Self Employed Professional

As a self employed professional you are responsible for establishing your own retirement plan.  Fortunately there are several options that can result in significant tax savings and help you eventually exit your business with a solid retirement plan.  Some retirement plan options for self employed professionals include a SEP IRA, Individual 401k, Defined Contribution Plan, Traditional IRA, and Roth IRA. Each of these retirement plans has unique features and rules that the self-employed professional should be aware of.

In this article I will be assessing the benefits and features of the SEP IRA with the assumption that the reader is a self-employed professional with no employees.  The goal is to maximize the tax benefits of saving for retirement.

SEP IRA

The Simplified Employee Pension (SEP) IRA is a Traditional IRA that allows for significant contributions by the self employed professional. This plan is a good way for a self employed professional to save a significant amount of income towards retirement in a tax advantaged way. 

The plan allows the self employed professional to contribute 20% of their self employment earnings up to a maximum of $66,000 in 2023 and $69,000 in 2024.

Tax Treatment of the SEP IRA

The self employed professional will receive a tax deduction up front, earnings will grow tax deferred, and taxes will be due (at ordinary income tax rates determined by your tax bracket) when a distribution is made from the plan.  Distributions made prior to 59 ½ will also carry a 10% early withdrawal penalty.  Required Minimum Distributions (RMDs) must be taken from the plan starting at age 73.

Roth SEP IRA (New in 2023)

The Secure Act 2.0 created the opportunity to contribute Roth IRA dollars to a SEP.  These are after tax contributions (no tax deduction up front), contributions can be withdrawn at any time, earnings are subject to the 10% early withdrawal penalty, and there are no Required Minimum Distributions.

As of this writing the major brokerage firms are not yet offering the Roth SEP IRA option.

Investment Options

The contributions can be invested through a brokerage account into a wide variety of investment options including individual stocks, bonds, index funds, and anything else that is eligible for investment in an IRA. Some IRA custodians will allow investment in real estate and alternative investments such as cryptocurrencies. IRA funds cannot be invested in life insurance or collectibles.

How to determine the amount the self employed professional can contribute:

The general rule for a maximum employer contribution to a SEP IRA is 25% of the employee’s compensation.  For self-employed professionals the maximum contribution amount is a bit more complicated, and will generally be 20% of net self-employed earnings, or $66,000 (for 2023) whichever is greater.  There is a table in IRS form 550 that can be used to determine the contribution amount for self-employed professionals.

Example:

John is an independent contractor in the technology industry.  He has no employees and would like to save as much as possible for retirement.  In 2023 he had net self-employed earnings of $210,000 from his consulting work. John would like to make the maximum contribution of 25% of compensation. Looking at the form 550 chart, John can contribute 20% of his earnings to his SEP IRA plan, or $42,000. If John had instead made $330,000 or greater he could have contributed the maximum $66,000 in 2023.

How to set up a SEP IRA for a self employed professional:

The first step is to set up the plan document using IRS form 5305-SEP.  If you have already selected an investment firm they will provide you with this form or a similar form during the account opening process.  This document will include the rules for plan eligibility.

The most restrictive eligibility requirements available are:

• Age 21

• Employed in 3 of the last 5 years

• Compensation of at least $450

Assuming you have no employees these restrictions will also apply to you as the self-employed professional.  It is OK to set these limits to be less restrictive so that you will qualify.  For example, if you are just starting your business you could set the number of qualifying years as zero.

You may also choose to exclude employees covered by a collective bargaining agreement and certain non-resident aliens.

The next step is to choose a firm that you would like to hold your account.  This could be a discount brokerage firm such as Schwab, Fidelity, or Vanguard or it could be a full service firm.  If you are working with a financial advisor, he or she can walk you through the process. 

Once the plan document is established you will open a Traditional (or potentially a Roth IRA) brokerage account to hold and invest your contributions.

Once everything is set up you can make your Traditional or Roth contribution to your SEP IRA.  Don’t forget to invest the funds in an appropriate investment strategy to build wealth for your retirement!

What is the timing of the SEP IRA for self employed professionals?

The SEP IRA plan can be established and contributions can be made up to the tax filing deadline (including extensions) for that tax year. It is important to note that the brokerage firm you are working with will report the SEP contribution in the year it is made even if it is a contribution for the previous year (for example a contribution made in July 2024 for the 2023 plan year will be reported in 2024). It is important that you and your tax advisor keep detailed records of your contributions.

What if I hire an employee in the future?

Generally, you must contribute the same percentage of compensation to the employee as you do for yourself.  Keep in mind that you can set eligibility requirements and it is OK to change to requirements in later years.  For example, in your first year of business (when you were the only employee) you had set the eligibility to zero years of service.  Now it has been three years and you have decided to hire an employee.  You could then amend the plan to require up to 3 or the past 5 years of service.

Can I also contribute to a regular Traditional IRA or Roth IRA in the same year?

Yes, although your contribution amounts may be limited due to the SEP IRA.

Whether you choose a SEP IRA, individual 401k, or other options saving for retirement in a tax advantaged way can be a powerful wealth building tool for the self-employed professional.  We will look at some of these other options in future articles. As with any tax information you read on the internet make sure to check with your tax advisor to apply this new knowledge to your individual situation.