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SEP IRA – Simplified Employee Pension Plan

by Ryan Guina

This is a guest article by Robert D. Flach.  Robert has been preparing business and individual tax returns for people in all walks of life since 1972.  He writes the tax blogs THE WANDERING TAX PRO and the NJ TAX PRACTICE BLOG.

Ryan has asked me to write a guest post on the topic of retirement plans for the self-employed.  Because there is so much information to present I will do so in several parts.

Self-employed individuals have many types of retirement plans from which to choose.  While these plans are available regardless of the type of business “entity” chosen, I will be discussing them from the point of view of the Schedule C filer.  In such a situation the determination of the amount of the allowable contribution begins with the “net profit” reported on Line 31 of Schedule C or Line 3 of Schedule C-EZ.

All of the retirement plans that I will discuss are available to the one-man business with no employees, and I will limit my discussion to the contributions of the business owner.  However these plans will require coverage of any qualifying W-2 employees of the business, and special rules will apply to contributions for employees.

SEP IRA – Simplified Employee Pension Plan

The first, and easiest to create and maintain, is the SEP, aka SEP-IRA.  SEP stands for “Simplified Employee Pension”.  Basically a SEP is a traditional IRA account, although the contribution limitations are much higher.  A separate IRA account is established for each covered participant.

Plan establishment and contribution deadlines. A SEP IRA, like the Traditional IRA, it is one of the few things you can do to reduce your tax liability after the ball drops on One Times Square on December 31st (FYI, the ball is dropped by one of my 1040 clients). The biggest benefit of the SEP, other than its simplicity, is that you have until the due date of the Form 1040 that includes the Schedule C or C-EZ for which the contribution is being made, including extensions (as late as October 15th of the next year), to set up the plan and make the contribution.

SEP IRA Contribution limits. For 2008 one can contribute up to $46,000 to a SEP.  This is increased to $49,000 for 2009.  The amount of the contribution is 25% of “compensation.”  For the owner of a Schedule C business this translates to 20% of the net profit on the Schedule C or C-EZ less the “above-the-line” adjustment to income for 50% of “self-employment tax.”

Example SEP IRA contribution:

The “bottom line” of John Q Puhlic’s Schedule C is $80,000.  This is John’s only “earned” income (i.e. he has no W-2 income).  His self-employment tax is $11,304, so the 50% deduction is $5,652.

John’s maximum SEP contribution is $14,870, calculated as follows:
$80,000 – $5,652 = $74,348 x 20% = $14,870.

We can prove this as follows –
$80,000 – $14,870 = $65,130 – $5,652 = $59,478 “compensation” x 25% = $14,870.

If the $80,000 was earned in 2008 John can submit a Form 4868 Application for Automatic Extension and wait until the first week of October 2009 (technically October 15, 2009) to create the SEP and make the contribution.   John does not have to contribute the full $14,870.  He can contribute any amount up to $14,870.

SEP IRA contributions are not mandatory. You are not required to make a contribution every year that there is a net profit or to maintain a particular level of contributions.  You can choose to contribute the full amount one year, only 10% the next, and nothing at all, even though there is a net profit, the year after.

Serve one, serve all. To establish a SEP you must have a written agreement to provide benefits to all eligible employees.  The self-employed owner is considered to be an “employee” for SEP purposes; an owner-employee is both an employer and an employee.  You can use the IRS model SEP plan document – Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement.

Benefits of a SEP IRA

Here are some of the reasons a SEP IRA might be a good retirement plan option for you or your small business:

  • Light administration. Easy to set up and maintain.
  • Contribution deadlines. You have until the tax filing deadline to establish and fund your SEP IRA.
  • Large contributions. You can contribute up to $46,000 in 2008 ($49,000 in 2009).
  • Immediate vesting. Once the individual SEP-IRA account is established with a bank or mutual fund or brokerage house or any other financial institution the owner-employee is 100% vested.  The minute the contribution is made to the account the money belongs to the employee.  Withdrawals from a SEP-IRA account are treated the same as from any other IRA account, with the same 10% penalty for premature withdrawal.

You can visit the IRS SEP rules page for more information on the SEP plan.

Here is more information about Self-Employed Retirement Plans.


Published or updated January 6, 2014.
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{ 7 comments… read them below or add one }

1 Jennifer R christiansen

Thank you for your web site. I find it vry helpful. I thought I saw somewhere that one could struture a SIMPLE plan as a Roth? Am I correct in understanding that? Thank you.

Reply

2 Ryan

Jennifer, I couldn’t find any information supporting the structure of a SIMPLE plan as a Roth. I would contact a tax professional or the IRS for more information. Best of luck!

Reply

3 Badri

Ryan,
I missed deadline to open SOLO 401k for 2009 tax year. So, my only option now is to open SEP. Is there a way we can concert SEP to SOLO later? If yes, what are the rules? Another question is on the SOLO 401K forum, Is there any remedy or any providers that can take solo 401k now for 2009 tax year before I open a account and streamline the account? Please advice. Thanks.

Reply

4 Ryan

Badri, I believe there are ways to convert a SEP IRA into a Solo 401k, but the details of having more than one of these plans at the same time or rolling a SEP IRA into a Solo 401k are outside the scope of my knowledge. I recommend contacting a tax professional for more information. Best of luck.

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5 Badri

Ryan, One more question on SEP IRA. The LLC company is on my wife’s name. And I do some work like depositing checks and operating the debit card and banking transactions. In this scenario, when I open the SEP account on my wife’s name, Do I also have to be part of SEP as joint account holder? Am I considered employee? I work full time elsewhere and draw my salary from that other unconnected company. I just work little bit for my wife’s company. Please let me know if you need more information. Thanks again.

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6 Badri

Ryan – A followup question. Can I do SEP this year and open a SOLO 401K at the end of this year, so that I can contribute to solo 401K at tax time next year to take advantage of higher deductibles? Thanks.

7 Ryan

Badri, You can be an employee for your wife’s company as well as an unrelated company. The key thing to remember in that situation is to not contribute more than allowed across all retirement plans.

For example, with a 401k you can only contribute $16,500 across all 401ks if you are under age 50. So if you had a 401k through your day job and a Solo 401k you could contribute $8,500 through your day job and $8,000 through the Solo 401k, or any other combination, not to exceed $16,500. That is separate from the employer match, or profit sharing. There are also limits for those contributions as well.

It would probably be best to open a SEP IRA for the 2009 tax year, and you can open a Solo 401k for the 2010 tax year at any time and begin contributions for the 2010 tax year as soon as the account is open.

You may wish to contact an accountant for more information – using an accountant was one of the best business decisions I made.

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