The SEP IRA allows business owners to deduct up to $58,000 and put that money towards retirement.
This is thousands of dollars more than the $6,000 contribution limit that a standard traditional or Roth IRA account allows you to deduct.
So if you are self-employed, earning income, and NOT taking advantage of the SEP or Solo 401K, get ready to cut your tax liability and save more money for retirement.
Today, we want to help you do this by taking advantage of SEP IRAs.
By the end of this post, we want you to know everything about it so you can start reaping the tax benefits.
With that said, let’s discuss the SEP IRA.
What is a SEP IRA?
A SEP IRA, which stands for Simplified Employee Pension, is a simple plan that allows employers to contribute to individual retirement accounts.
SEP IRAs came about as a way to provide an easy method to set up retirement accounts without all of the start-up and administrative costs of conventional retirement plans.
Other retirement plans have annual filing requirements, require a ton of paperwork, and can cost an arm and a leg to administer. There are normally:
- setup fees,
- management fees,
- administrative fees,
- investing fees,
…and so much more.
But SEP IRAs are not as costly.
Vanguard, for example, charges no setup fees and a minimal $20 fee for account services, which can be waived.
So that’s what a SEP IRA is.
What Are the Benefits of a SEP IRA? Why Should You Create One?
As if the benefits of compound interest and saving for retirement wasn’t enough, there are some major tax benefits of starting a SEP IRA.
The maximum contribution is adjusted annually but at the time of this post, you can contribute 20% of your self-employment income up to $58,000!
And the good news is that your contribution is tax-deductible.
So if you ended up contributing $58,000, that would lower your taxable income by that amount, resulting in lower taxes for you.
So in short, you’re saving up to $58,000 for your retirement, which is then compounded by an investment vehicle you choose, like stocks or bonds.
And then when tax time comes around, you deduct your contributions from your tax liability, putting even more money in your pockets.
With the contribution limit of traditional IRA accounts being only $6K-$7K, this definitely makes a SEP IRA an attractive option.
But let’s break this all the way down.
How a SEP IRA Works
So with a SEP IRA, you can contribute 20% of your self-employment income.
Your self-employment income is your net income. In other words, revenue minus all expenses equals your self-employment income.
Therefore, if your self-employment income is $50,000, you can contribute $10,000 to your SEP IRA.
If your self-employment income is $100,000, you can contribute $20,000. And so on.
So in order to deduct up to $58,000, your self-employment income would have to be over $200,000.
Regardless of your income level, the SEP IRA contributions will likely save you more money than the $6000 traditional IRA contribution limit.
For example, if you make $100,000 per year and can deduct $20,000, that brings your taxable income down to $80,000.
Let’s just say you’re in a 20% tax bracket, that would mean you’d save at least $4,000 by investing $20,000 into your retirement.
That’s less money for Uncle Sam and more money compounding towards your retirement.
Also, it’s important to note that self-employment income is treated differently than W-2 income.
While contributions are limited to 20% of self-employment income, if you are receiving W-2 wages from your business, you can instead contribute 25% of that income source.
So that’s $12,500 if you’re making $50,000, $25,000 if you’re making $100,000, and so on.
Anyway, that’s how the contributions work in a SEP IRA. Now let’s look at some pros and cons.
The Pros and Cons of a SEP IRA
As stated earlier, the pros of the SEP are the high contribution limits, tax benefits, and the ease of administration in comparison to other options.
But let’s look at some potential cons that may come up as well.
1. If you have employees, you have to equally contribute to their IRA plan as well.
But if you are a freelancer, contractor, consultant, coach, or any business where you’re the only employee, then you don’t have to worry about this.
Instead, you get all of the tax benefits for yourself.
2. There are no Roth contributions.
Many IRA options have the ability to take advantage of Roth, meaning that you invest after-tax dollars. However, SEP IRAs are limited to traditional investing.
3. You cannot take loans from a SEP IRA.
While other IRA options do allow you to take loans from your account, a SEP IRA does not.
Remember, the SEP IRA is all about simplicity. So unfortunately this is another feature that is just not possible within the SEP IRA framework.
So ultimately, if you are not investing money into ANY retirement account right now and you’re operating a business, then you’re probably leaving some money on the table.
And you’re paying your hard-earned money in taxes and could instead be using that to save on taxes and build wealth for retirement or other things.
A SEP IRA is a simple, low-cost way to do this. It’s simple to set up, low-cost-, and has high contribution limits that make everything worthwhile.
If you want more of the features we described earlier, like Roth options, the ability to take loans, and even HIGHER tax savings, then you should consider looking into a Solo 401K.
A Solo 401K is a more sophisticated version of a SEP IRA, with more features, but also adds some more complexity.
And if you want to save on taxes this tax season, why not work with LYFE’s tax experts?