BENEFITS

SEP Tax Deduction

A Simplified Employee Pension (SEP) or SEP IRA is a retirement plan anyone with self employment income is eligible to establish. Similar to traditional IRA's, SEP's allow you to contribute a portion of your income to your retirement account without paying income tax on your contributions until you withdraw them (presumably when you retire). However, unlike a traditional IRA, the contribution and deduction limits for a SEP IRA is much higher, equal to the lesser of 25% of employee compensation or $55,000 (2018 limits). Further, you can deduct contributions to your own plan, and contributions to the plans of your employees, which can create significant tax savings for entrepreneurs.

PROFESSIONAL SCALE

Pinter is a 32-year-old sole practitioner nutritionist who had $90,000 of self employment income (after retirement contributions and deductible self employment tax) during the year. Since his business had a great year, Pinter elected to make a contribution to his SEP IRA of $22,500, or 25% of his net self-employment income. Peter will be able to offset his current year taxable income by $22.500 by deducting his contribution on line 28 of his Form 1040. He will however have to pay income taxes on his contributions when he begins taking distributions from his account later on in life.

ENTREPRENEUR

Tina is a sole proprietor tech entrepreneur whose startup gained serious traction during the year, providing Tina with $300,000 of net self employment income (after retirement contributions and deductible self-employment tax). Tina has a SEP IRA and naturally wants to contribute as much as she can to help defer some taxes and set herself up for retirement. Since the 2018 maximum SEP IRA contribution is limited to the lesser of 25% of net self-employment income or $55,000, Tina would only be able to contribute and deduct $55,000 during the year as 25% of her compensation would total $75,000, which is above the IRS limit.

TASKER

Tony is a tasker who can do anything you could ever want done around your house. He has one full-time employee. Both Tony and his employee have SEP IRA's. During the year, Tony had $66,000 of net self employment income (after retirement contributions and deductible self-employment tax), his employee had $35,000 of W-2 wages. Tony chose to contribute 10% to his SEP IRA and his employee's SEP IRA. Accordingly, Tony could deduct $6,600 for his own contribution on line 28 of his Form 1040, and $3,500 for the contribution he made to his employee's account on line 19 of his Schedule C.

AUTHOR / SPEAKER

Emilia is a 48-year-old professional speaker who once had a lucrative career giving presentations on dial-up internet. Recently, due to advances in technology, she fell on hard times. During the current year, she withdrew $25,000 from her SEP IRA to help pay for living expenses while she searched for a new job. Unfortunately, upon withdrawing the money, Emilia had to pay a 10% early withdrawal tax plus income tax on the money she took out of her IRA (since SEP IRAs are tax-deferred).

REAL ESTAE AGENT

Anoush is a 27 year-old independent real estate agent who recently established a SEP IRA so he could defer tax on some of his commission income and save for retirement. Since SEP's don't have any reporting requirements, all he had to do was find a trustee (Fidelity, Merrill Lynch, etc.) to keep his account with and execute a written agreement outlining the his SEP plan benefits (Anoush used IRS Form 5305-SEP). Since Anoush chose the SEP over more complex profit sharing plans, setting up his plan was easy and he doesn't have to worry about ongoing reporting and compliance issues.

MORE ON RESEARCH AND EXPERIMENTATION

  • If you have self-employment income you are eligible to establish a SEP. If you are a sole proprietor you can contribute and deduct the lesser of 25% of your net self-employment income (including of deductible part of self-employment tax and contributions to your retirement plan) or $55,000 in 2018, whereas traditional IRA contributions are limited to the lesser of $5,500 or your total compensation.
  • SEP's follow many of same rules as traditional IRA's, including the 6% tax on excess contributions (and any earnings on your excess contributions) and 10% tax on non-qualifying early withdrawals.
  • SEPs do not have onerous reporting, administrative or compliance requirements like some other "high limit" retirement plans, but you have the benefit of being able to make contributions of a similar amount.
  • Keep in mind that if you have an SEP IRA and make contributions for yourself, in most cases, you will also need to establish SEP IRA's for your employees and make contributions for them as well.
  • If you have a SEP, contributions you make for yourself are deductible on line 28 of your Form 1040. Contributions you make for employees are deductible on line 19 of your Schedule C.
  • There are many details surrounding SEP IRA's that we have not included on this page. Different guidance may apply to you depending on your specific situation. Further, SEP IRA's are just one of many investment vehicles you could choose to take advantage of. You should consult with your tax advisor and financial planner to determine how this deduction could apply to you specifically.

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