How business owners can reduce their tax bill and boost retirement savings with a SEP IRA.
A SEP IRA offers business owners the benefits of accelerated retirement contributions from a workplace retirement plan with the simplicity and flexibility of a regular IRA. Typically adopted by small business owners (sole proprietors, partnerships, C and S corporations) and part-time entrepreneurs, a SEP IRA can be set up and funded as late as the tax filing deadline—including extensions. For the 2019 tax year, a business owner with no employees could reduce their taxable income by up to $56,000 and keep the money to invest for retirement. It’s a win-win!
How business owners can trim their tax bill with a SEP IRA
SEP IRAs are almost always funded exclusively by the employer–employees generally cannot contribute to this type of retirement plan. You can start a SEP whether you have employees or are a solopreneur, but contributions must be made equally as a percentage of compensation across all eligible employee accounts. Strapped for cash one year? That’s ok—you can skip the SEP.
To be eligible to participate in a SEP IRA, employees must be over the age of 21, have worked at the company for at least three of the last five years, and received at least $600 in compensation for the business year. You could make the requirements less stringent if you wanted, but they just cannot be more restrictive than this.
If your business is taxed as a C corporation, S corporation, multi-member LLC, or partnership, the SEP contribution(s) will be deducted as a business expense. This will reduce the net taxable income for the business, which in turn reduces the taxable income that will be passed through to an owner on their K-1.
For sole proprietors, a SEP contribution will become an above-the-line deduction on your personal tax return. It’s generally advisable to get a CPA to help calculate your SEP contribution and tax deduction, particularly if you have employees and/or are self-employed as there are some nuances.
SEP contribution limits
As with any retirement plan, there are limits on how much the IRS will let you contribute. For the 2019 tax year, SEP contributions are limited to the lesser of 25% of W-2 earnings, or 20% of net income if self-employed, or $56,000. Keep in mind that these are the maximum amounts—you can contribute a smaller percentage if you choose and can change the contribution amount every year as cash flow allows.
For the purposes of this calculation the IRS caps earnings at $280,000 in 2019, which is called the covered compensation limit.
Again, as a business owner, you do have discretion as to whether to make an annual contribution and in the amount, but the decision must be applied uniformly across all participants and within specified limits.
Due to the eligibility requirements and required uniform contributions, SEP IRAs are most commonly used by business owners without employees or very small companies.
The most flexible type of retirement plan
The SEP IRA is perhaps the most flexible type of retirement plan there is:
- No IRS filing: SEP IRAs are not subject to annual IRS filings
- No impact on other IRA contributions: employer contributions to a SEP generally will not impact the ability for the business owner or employees to make annual additions to a Traditional or Roth IRA, (subject to regular annual limitations and income thresholds for tax-deductible and Roth contributions)
- Funding flexibility: since you can wait until after the year is over to decide what SEP contribution you want to make, there’s little downside as you can even choose to forgo the contribution altogether in bad years
- Easy to set up: you or your financial advisor can set up a SEP IRA at a financial institution, which can be invested how you choose and in conjunction with your other accounts
- Running a business part-time or as a side-gig? No problem, you can still open a SEP IRA. You can even use a SEP IRA if you’re participating in a 401(k) at your full-time job.
Nothing is perfect
Like anything else, a SEP IRA isn’t perfect. Given how contributions are calculated, unless you have significant income, your SEP-savings might be too small to make an impact. Further, because contributions must be made using equal percentages and funded exclusively by the employer, SEP IRAs don’t always make sense financially for businesses with staff.
For business owners without employees (except for a spouse), a solo 401(k) may be an even better way to save for retirement and reduce your taxable income due to the higher contribution limits. Although it’s too late to set one up for the 2019 tax year, it may be a great time to start one for 2020.