Self-Employed? Here’s Why You Need a SEP IRA

Being self-employed can be great: You have more freedom and flexibility, and working for yourself can be financially rewarding, too.

As a self-employed person, you have another possible big opportunity, too: setting up a Simplified Employee Pension (SEP) IRA. With this move, you can potentially save even more for retirement than you could with a 401(k). A SEP IRA can be a good way to get started saving towards your biggest financial goal—financial independence.

A SEP IRA may be ideal if you’re a successful self-employed professional with no employees and you want to shelter your income from taxes and invest for retirement. Here’s why. When you’re self employed and receive 1099 income, you pay both the employer and employee portions of Social Security and Medicare taxes. Contributing to a SEP reduces these costs, along with federal and state income taxes.

The SEP also gives you the flexibility to decide how much you want to save each year, as well as potentially much higher contribution limits than the $6,000 limit of a traditional IRA ($7,000 if you’re 50 or older)—and it can be just as easy to set up. It can be a powerful wealth management tool.

Understanding Your SEP IRA

A SEP IRA lets you contribute up to 25% of the net profits of your business—with an upper limit of $58,000 for 2022 and $61,000 for 2022—in total annual contributions. These contributions are made by you as the “employer.” They are tax deductible from your business income. (Withdrawals you make in retirement will be taxed as ordinary income.) As with a traditional IRA, you pay a 10% penalty for any withdrawals you make prior to age 59½, unless one of the usual exceptions applies—death, disability, medical expenses, and so on. It’s easy to open a SEP with most financial institutions—including SoFi Invest.

Contributing to a SEP doesn’t stop you from also contributing to a Roth IRA if your income is under the Roth income limits ($129,000 for single filers or $204,000 for joint in 2022). Better yet, even if you also have a job and are eligible for an employer’s retirement plan, you can still make a SEP contribution if you have business income in addition to that job. This may be valuable for anyone who has both a full-time job and freelance income or a side gig.

You can use a SEP if you have employees, but it’s more complicated and generally you must contribute the same percentage of income for each employee as you do for yourself. (After all, the boss shouldn’t get all the benefits.) There are better retirement plan options for most companies with employees.

Calculating Your SEP IRA Contribution

You can set up a SEP IRA for a given year as late as the due date of your business’s income tax return for that year (including extensions). If you’re a self-employed sole proprietor, your business return is probably Schedule C of your personal income tax return. So if you file an extension for your 2021 tax return, you can still establish a SEP and make your contribution for 2021 as late as October 15, 2022, regardless of when you file your return. If you filed your 2021 taxes on time, your first contributions will be for tax year 2022.

Your contribution depends on your net profit as calculated on your Schedule C. This net profit is net of, among other things, your SEP contribution. A 25% contribution ends up being about 18.6% of your income. Yes, this is a circular calculation that could drive you crazy. You could use this IRS form, but it’s probably easier to have your tax preparer or tax software calculate your contribution instead. If you have a good idea of what your self-employment income will be, you can get a quick estimate from our IRA Calculator.

Of course, you won’t actually know how much money you actually made in 2022 until the year is over. This is especially true for people like attorneys, real estate agents, and others who might get large payments, but at irregular intervals that can be hard to predict. Also, people with a side gig often don’t know how much they’ll make in a given year. If you’re one of these people, you should make your contribution after your tax return is completed.

However, if you’re a consultant, a physician on contract, or anyone else who has steady, predictable income and expenses, you may want to make some contributions throughout the year. Regular periodic contributions give you the benefit of not timing the market and put more money to work for longer toward your retirement.

Since it’s a real hassle to unwind an over-contribution and there’s a stiff penalty if you don’t do it right, consider regular contributions of 5% or 10% of the net income you’ve earned in a given month. You can stop or adjust your contribution if your income drops (or expenses jump up), and then top off the account with a final contribution once your taxes are calculated.

Getting Started with a SEP IRA

Since your SEP is your company “pension” plan, it needs a plan agreement. The IRS has a very simple form for this: 5305-SEP

The form takes only a few minutes to complete, and you don’t even have to file it with the IRS. Just keep it for your records. The document formally establishes your plan in case you ever get audited.

A SEP IRA is a low-cost, flexible retirement plan for self-employed professionals. If you open an account and start contributing today, you could cut your tax bill and start investing for your retirement now. And remember—the higher your income, the sweeter a deal it is.

Learn More

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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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