If you’re self-employed, you may think that a regular IRA plan is the only option for saving for your retirement. But there’s something else you may not even know exists: the Simplified Employee Pension (SEP) Plan. And it offers some real advantages to freelancers.
In order to qualify for an individual SEP IRA, you must be self-employed in some way. That could mean owning your own business (with real live employees), but the good news is that it also applies to those of us who earn a living as hard-working freelancers / sole proprietors.
What’s so special about a SEP plan?
While the SEP plan offers a lot of the same features of a traditional IRA, it also comes with some nice advantages:
Some of the similarities
- Easy to set up with the help of your banker or broker
- Tax deductible
- Your money grows tax-deferred until needed
- Withdrawals before 59 1/2 taxed as regular income and subject to 10% penalty for early withdrawal
- Withdrawals after 59 1/2 are taxed at your then current rate, but no withdrawal penalty
- Required minimum distributions by age 70 1/2
Some of the key advantages of a SEP
- You can contribute much more than you can to traditional IRAs
- For 2016, your maximum contribution is 25% of salary up to $53,000
- With a higher maximum, your annual tax advantages can also increase*
- You can still choose how much of your income you want to contribute
- You can still put retirement money into a traditional IRA or ROTH IRA
*NOTE: For freelancers / consultants making enough money, the ability to take advantage of higher deductions is especially useful at a time when your income may be far higher (therefore more taxable) than when you retire.
Comparing a SEP IRA vs a traditional IRA
As mentioned, a SEP IRA allows you to contribute much more each year than a traditional or even a Roth IRA. That not only increases the amount you can eventually have stashed safely away for retirement, but it lets you take advantage of a potentially bigger tax deduction in the current year.
While those accounts have a maximum contribution of $5,500 or $6,500 (for those 50 or older) per year, a SEP IRA allows you to contribute as much as 25% of your annual earnings, up to a current maximum of $53,000.
Let’s say, for example, that you’re able to put away an extra $5,000 each year. In 20 years time you could have an additional $162,623 in your retirement savings, using an average 5% a year growth rate for your market investments. (Of course, you won’t get that rate if you keep all your money in a savings account that pays well under 1% as so many do now.)
What if I have employees or sub-contractors in my business?
Good news. If you want to offer them a retirement plan, you can set up a SEP IRA for each of them as well. Only you as the owner would contribute to the employees’ accounts, and you can vary the contribution amount each year. In addition, the contributions you make are once again tax-deductible!
One of the best features for employers is that there’s very little paperwork to deal with. Still for this plan to be qualified in the eyes of the IRS, each qualified employee must receive an account, and you must contribute to every employee’s account at the same rate.
Where can you invest your SEP contributions?
When it comes to investing choices, a SEP IRA is like a traditional IRA in that it lets you invest in lots of investment products, including stocks, bonds, etf’s, and mutual funds. The exact products available to you may depend on the bank or broker you set the account up with. But any reputable firm should offer you a variety of investments.
Since we’re talking about ways to have more when you need it later on, my strong suggestion is to find banks or brokers who let you invest in “no load” investments, meaning you don’t pay an extra fee when you buy or sell. The broker may charge a small one-time sales fee, that’s normal. But please beware of mutual funds and other investments that cost you as much as 4% or more just to have the honor of buying into it.
Just know that there are many excellent funds (Fidelity, T. Rowe Price, Vanguard and more) with zero extra “load” fees. If your brokerage firm can’t help you with that, I suggest you look for another broker – even if they swear the growth will far outweigh the fee. It rarely does.
How does the IRS tax my SEP money?
Taxes are treated like a traditional IRA. You don’t pay income taxes on money you deposit into the account. And there are no capital gains taxes along the way, so your money can compound without worrying about taxes. You only have to pay income taxes when the money is withdrawn.
And as mentioned before, by the time you need your money, your tax rate will probably be a lot lower than when you were making it. Or at least it may be the same. But with the help of those larger deductions, you will feel the benefits of extra cash flow in real time.
And remember, retirement money is not needed all at once, so most likely you won’t be taking a huge tax hit from a lump sum withdrawal that might raise your tax rate. Although that’s certainly something to be aware of should the need to withdraw a lot at once arise.
How do I go about setting up a SEP IRA?
You can set up a SEP IRA at any broker or financial institution at any time. In that way, it’s just like a traditional IRA or a taxable brokerage account. And if you’re a freelancer, there’s almost nothing more to do than fill out a few forms that they can help you with.
Getting to know your investments