Solopreneurs and SEP IRAs
Are you self-employed with no employees? Then you may want to consider a SEP IRA as your first option for a self-employed retirement plan.
When is the best time to set up a SEP IRA? My #1 tip: If you are ready to contribute more than the maximum Traditional IRA contribution limitation ($6,000 for 2020, plus an additional $1,000 catch-up for those 50 or older), then you are likely ready to establish a SEP IRA.
What tax status is best for a SEP IRA? If you file as a sole proprietor with a Schedule C, you are probably a good fit.
How much can you contribute each year? You can contribute up to the lesser of:
20% of your net earnings from self-employment (which is also 25% of your compensation) or
$57,000 for 2020.
How do you calculate 20% of your net earnings? This is where the fun starts! Here’s a basic formula.
Is the calculation really that straightforward? Ummm… no, not really. If you look closely at that formula, you end up determining the amount of your SEP contribution based upon how much you actually contribute. Make sense? Probably not. To help, the IRS created a special Rate Table (in IRS Publication 560) for us to use. The end result provides us with a contribution amount that is both 25% of compensation and 20% of net earnings from self employment. Confused yet? Probably. But trust me, just use the Rate Table. Your SEP IRA contribution will add up to what it’s supposed to.
Note: You won’t know the exact amount you are eligible to contribute until you file your tax return. So be prepared at tax time with the required cash to make a SEP IRA contribution, plus to pay any tax balances due.
When should you not have a SEP IRA?
If you have employees, you may want to consider a Simple IRA or 401(k) instead. Why? Because if you contribute 25% of your compensation to your plan, then you also must contribute 25% of your employee’s compensation to his or her plan.
If you’re an S-Corp, definitely consider a Simple IRA or a 401(k) instead. You’ll find some additional tax benefits, mainly related to employer contributions not being subject to the employer’s portion of FICA.
If your self-employment income significantly varies year to year, consider a solo 401(k) instead. Why? SEP IRA contributions are based upon a percentage of net earnings from self employment. In years your net earnings are low, your SEP IRA contributions would also be low.
As always, make sure to discuss your situation with a tax professional or investment advisor, as there are generally other pros and cons for setting up a self-employed retirement plan. In addition, the IRS requires you to create a formal written plan (usually a Form 5305-SEP) when setting up a SEP IRA.
For more information, refer to the IRS Publication 560 and the IRS SEP Plan FAQs.