How the Self-Employed Can Save for Retirement With a SEP-IRA

It's easy to set up and the pre-tax contribution amount is generous

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If you are self-employed or a small business owner and are looking for a retirement plan for you and your employees, a SEP-IRA may be the right choice. SEP stands for simplified employee pension. This type of plan is an individual retirement account, or IRA, into which business owners can make pre-tax retirement contributions for themselves and their employees.

Compared to a 401(k) retirement plan, a SEP-IRA is relatively simple to start and manage. There's far less paperwork, and no annual filing is required, according to the Internal Revenue Service. Plus, annual contribution limits are much higher than you'll find in most other retirement plans.

As with other tax-advantaged retirement plans, contributions to a SEP-IRA can be invested tax-deferred until the money is withdrawn at retirement, beginning at age 59 1/2 and no later than age 70 1/2. If the money is withdrawn before age 59 1/2, it is subject to income tax plus a 10 percent penalty tax.

Completely Deductible

Business owners can completely deduct SEP-IRA contributions as a business expense. And employees do not have to count contributions in their gross income, so they're considered pre-tax income, like they would be in a 401(k).

As with other types of IRAs, self-employed people usually have until the tax-filing deadline day in mid-April to make contributions to a SEP-IRA for that tax year. If you file an extension, you may have until October 15 to fund a SEP-IRA for the prior year. The same deadlines apply for creating a SEP-IRA.

Contribution Limits

One of the most appealing aspects of a SEP-IRA is its high contribution limits. Contributions for employees can equal as much as 25 percent of their gross annual salary, and contributions for business owners can amount to 20 percent of their net adjusted annual income from self-employment. The maximum amount for both employees and employers is $56,000 in 2019.

Compare that to the 401(k), which has a maximum contribution limit of $19,000 in 2019 (or $25,000 if you're 50 or older and so qualify for a catch-up contribution), and you can see the obvious benefit for those who are looking to save more tax-deferred dollars.

Even if you participate in another workplace retirement plan, like a 401(k), you can still contribute self-employment income to a SEP-IRA, so it's a great plan for people who earn income from a side business, including freelance or contract work.

Calculating Self-Employment Income

If you are self-employed, figuring out how much you can contribute each year can be slightly tricky. You can calculate net adjusted self-employment income by taking your gross income, subtracting business expenses and then subtracting half of the self-employment tax. But you must include your contribution to the SEP-IRA in your business expenses. Consult with an accountant or tax advisor if you have any questions.

You do not have to contribute the same amount each year to a SEP IRA. And if you want to contribute nothing in a given year, that's OK too.

Contributions to a SEP IRA are a little less flexible once additional employees enter the picture. That's because employers must contribute the same percentage for every employee. Let's say you're a dentist who wants to contribute 20 percent of your income to a SEP-IRA. You must also contribute 20 percent of each of your employees' salaries to a SEP-IRA as well. All employees who are age 21 or older, have worked for you for three of the past five years, and were paid at least $600 in 2019 are eligible for this contribution. (Employees working under union agreements may be excluded.)

Other Options

There are other retirement plans for small businesses and self-employed individuals, such as SIMPLE IRAs, solo or self-employed 401(k)s, Keoghs, or even regular 401(k)s for small businesses. It makes sense to compare them all before deciding which one is right for you.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.