Navigating financial planning as someone who is self-employed can sometimes be an overwhelming maze of trying to pay taxes, find health insurance, and save for retirement.
Planning ahead for retirement is something that might get easily overlooked by many freelancers or contractors. In fact, only half of all Americans have access to a 401(k), making alternative methods of saving for retirement that much more important.
A SEP IRA allows a self-employed individual or a small business owner to make retirement contributions into a traditional IRA. SEP IRA rules make it so that the account is established in the employee’s name, not the business’s.
Traditional IRA vs. SEP IRA
Traditional IRAs allow deductions on account contributions on tax returns, meaning taxes will have to get paid on withdrawals upon retirement.
Under a SEP IRA, employers generally must contribute a uniform percentage of pay for each employee, although they do not have to make contributions every year. This flexibility is why some small businesses and self-employed individuals might want a SEP IRA retirement plan, due to the volatility of their income year over year.
A SEP IRA, or a Simplified Employee Pension IRA, is one kind of IRA geared toward people who are self-employed, or small business owners.
Since an IRA is meant for retirement savings, sometimes people who are freelancers or contractors might not have a retirement plan available if they work with multiple employers, and so they must set up their own account.
But the IRS also notes that an individual can still set up a SEP IRA for their self-employed business, even if they participate in another employer’s retirement plan at a second job. So, any business owner with one or more employees, aka a self-employed individual, or any person with freelance income, can open a SEP IRA .
Contributions to a SEP IRA are treated like a traditional IRA. They are held in the employee’s name, and are tax-deductible. Only an employer can maintain and contribute to a SEP plan for its employees, so if someone is self-employed they must, according to the IRS , be an individual who owns an unincorporated business, such as the sole owner of an LLC or business, or independent contractor. Like other traditional IRAs, money in a SEP IRA is not taxed until withdrawal. A SEP IRA does have a higher contribution limit than other IRA plans.
Being able to make contributions toward retirement as a self-employed individual, or contributing as a small business owner, is fairly straightforward under a SEP IRA. Employers must be the ones contributing for each eligible employee, who still owns and controls the account.
Who Can Open a SEP IRA?
Here is who qualifies to participate in a SEP IRA:
• Any employee who is at least 21 years old
• AND has worked at the company for at least 3 out of the last 5 years
• AND has received at least $600 in compensation during the year
Employers do not have to fund contributions every year, but if they do choose to do so, must contribute to the SEP IRA of every eligible employee, including themselves. Those eligible employees have to receive contributions equal in percentage to what the business owner puts away for themselves.
For instance, if an employee worked for a small business in 2017, 2019, and 2020, was over 21, and made at least $600 in 2021, their employer would need to make a contribution for that person in the 2021 plan.
If the business owner puts away 15% of their own compensation in their SEP IRA, they must also contribute 15% of the employee’s compensation to that person’s plan.
Also, while the 3-of-5 year eligibility rule is the most restrictive requirement, employers can also choose to use less restrictive rules , such as allowing employees to participate immediately after they begin work, or after a shorter period of employment, such as after only working for one year.
If an employer does use the 3-of-5 rule, they must count any work, no matter how little, in each of the prior 5 years. This also means using plan years (often the calendar year), not years based on the date the employee started working.
For people who share joint ownership of a business, both people must meet the SEP IRA rules individually in order to participate. The eligibility requirements apply equally to both owners and employees, whether of a small business or self-employment. Owners can also choose to exclude certain employees, According to the IRS , including those covered by a union agreement—if retirement benefits were bargained for in good faith—or nonresident aliens who have no U.S.-sourced compensation.
What Can Someone Contribute to a SEP IRA?
Just like other IRAs, there are annual contribution limits for a SEP IRA. However, SEP IRA accounts have a much higher monetary limit than other IRA plans. The contribution limits annually to a SEP IRA can not exceed the lesser of either 25% of total compensation, or $61,000 in 2022.
This limit also applies to the net profits of a business, and are also tax deductible from business income. Withdrawals in retirement are taxed as regular income.
Like with a traditional IRA, there is a 10% penalty for withdrawals before the age of 59½, unless one of the exceptions applies such as death, disability, or medical expenses.
An important difference between a SEP and other self-employment retirement plans is that a SEP is set up for small businesses as well. This ties back into having to contribute an equal percentage for each employee, meaning an owner of a business can not contribute more in percentage of their own compensation to their own retirement than that of an employee. A SEP IRA, however, is simpler to manage than a solo 401(k), in terms of paperwork and annual reporting.
special SEP IRA rules also apply when determining the maximum deductible contribution as someone who is self-employed. If a person makes contributions for themselves, they must calculate their compensation based on net profit from self-employment.
For example, the maximum 25% contribution might actually end up being about 18% of someone’s income, because it is based on profits and self-employment tax. A tool like an IRA calculator can help give a quick estimate before tax time.
While an individual might only be able to add $6,000 yearly with a traditional or Roth IRA, since a SEP IRA is income-based, the contributions can be higher depending on self-employed income.
Pros and Cons of a SEP IRA
A SEP IRA is perhaps most beneficial to individuals running a solo enterprise. But for a small business, a SEP IRA is often an easy, inexpensive means to set up a retirement fund.
Plus, contributions are tax deductible. The flexibility to not contribute annually, if the business had a hard year, or contribute more in a good year, is another reason a SEP IRA might be a good option for some.
For self-employed individuals, with no employees, a SEP IRA helps protect income and invest in retirement. After receiving 1099 income, the individual must pay the employer and employee sections of Social Security and Medicare taxes.
Contributing to a SEP can help reduce these taxes, along with federal and state. Giving someone the flexibility to decide what they want to contribute, and offering the option to go above the $6,000 limit of a traditional IRA , makes it a useful tool for self-employed people.
Using a SEP with employees does mean, however, that the owner must contribute that same percentage of income for each employee.
SEP IRA Pros
• High contribution limit of $61,000 in 2022 (or 25% of total compensation)
• Relatively easy to set up and make contributions
• Does not limit use of another account, like a traditional or Roth IRA
• Contributions are tax-deductible, including those made to employee accounts
SEP IRA Cons
• Individuals can not opt to pay taxes on contributions now
• If owner contributes for themselves, they must contribute the same percentage for all eligible employees
Opening a SEP IRA
There are three steps to opening a SEP, according to the IRS . SEPs have low start-up and operating costs, and can be established with just a two-page form. There must be a formal, written agreement using an IRS-approved document such as Form 5305-SEP , or an individually designed plan form.
Then, every eligible employee must be provided with information about the SEP. Finally, the employer must establish a SEP IRA for each eligible employee with a bank, insurance company, or other financial institution.
It’s possible to open a SEP IRA account at basically any bank or mutual-fund company or firm. While the employer makes the contributions, the employee still owns and controls the SEP IRA.
SEP IRA plans must also be updated to match current law . Make sure to calculate the initial allocations based on the SEP plan’s terms, and verify that all initial proposed contributions are based on that uniform percentage of all individual employee compensation amounts.
The forms do not have to be filed with the IRS, just kept and recorded for the individual or small business. It’s more of a formal way to establish the rules of the SEP IRA, in case of a tax audit. The law also does not require every participant’s SEP IRA to be at the same financial institution, though it might be easiest for business owners to do so.
What time of year a SEP IRA can be set up depends on the due date for that business’s income tax return. Self-employed, sole proprietors are likely already filing business returns as Schedule C of their personal income tax return .
So, if someone filed for an extension of their 2021 return, they could still establish a SEP and make contributions for 2021 as late as October 2022, regardless of when the return is filed. Filing by the tax deadline means the first SEP contributions would then be eligible for the 2022 tax year.
Invest in a SEP IRA
It is fairly straightforward to open a SEP IRA with most financial institutions, including with SoFi Invest. The sole proprietor or owner can select from the investments that the account provider offers, which usually includes stocks, bonds, and mutual funds.
While it is possible to set up an IRA with a bank, the investing is typically limited to Certificates of Deposit, which usually offer a lower return than a diverse group of bonds and stocks.
Remember, contributions must be made by the federal income tax return filing due date, including extensions. By deducting contributions, employees are able to exclude those contributions from their gross income, which is another key benefit that many self-employed workers might want to take advantage of.
Once the account is open, investments should be made according to current age, planned retirement age, and the desired speed of growth or risk. At SoFi, this means choosing investment strategies, from conservative to aggressive.
Members can also have separate portfolios for different goals, like retirement or a down payment. SoFi Invest® accounts for a variety of accounts and rollover options, offering traditional, Roth, and SEP IRAs.
Getting money into a SEP IRA works the same as any other retirement account, where funding the account can come from simply linking a checking or savings account. Most accounts will also allow for the set up of a recurring deposit, or individuals can choose to make one-time deposits, so long as they remain under the contribution limits.
SoFi members also receive complimentary financial planning with personalized advice from SoFi Financial Advisors. Then, just like any other IRA or retirement account, the goal is that a SEP IRA will help grow the money invested over time for retirement.
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.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
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