Tax Planning with Simplified Employee Pension (SEP) Plans

Use SEP (Simplified Employee Pension) IRAs to Save for Retirement

Small business owner doing paperwork
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Simplified Employee Pension (SEP) plans are a type of tax-deferred retirement savings plan for the self-employed and small business owners. With a simplified employee pension plan, a business can make tax-free contributions to an individual retirement account for each of its employees. SEPs are funded solely by the employer using tax-deductible dollars. Unlike other retirement plans, SEP plans do not offer Roth or post-tax contributions.

  • Employers can contribute up to 25% of each employee's annual compensation.
  • Self-employed persons can contribute up to 20% of their net self-employment earnings towards their own account.
  • Contributions are limited to a maximum dollar amount of $56,000 per plan participant for tax year 2019.

The SEP refers to a formal, written retirement plan adopted by the employer. The IRS has a model SEP plan that you can adopt (Form 5305-SEP). Financial institutions may have their own model plans.

SEP IRA refers to the IRA accounts set up for each plan participant. An employer adopts a SEP and then contributes funds to each participant's SEP IRA.

The Key Benefits of Adopting a SEP

  • Tax-deferred savings for retirement
  • Can be adopted as late as the due date of the tax return (with extensions) for the tax year in question
  • Can be funded as late as the due date of the tax return (with extensions) for the tax year in question
  • Employer-only contributions fund the IRA even if employee contributes nothing
  • Usually no need to file Form 5500 annually to report the retirement benefits
  • Usually less complicated and less expensive to maintain than other small business retirement plans such as 401(k)s
  • Employees are always 100% vested in the retirement funds
  • The contribution rate can vary each year

Tax Planning with Simplified Employee Pension Plans

Contributions to a SEP IRA are tax-deductible to the person or business funding the contributions. Thus SEP IRAs can play the following roles in tax planning:

  • Investment income earned inside the SEP IRA is tax-deferred
  • Contributions can be made after the end of the tax year
  • Participants control how the contributions are invested
  • Can be rolled over to traditional IRAs
  • Can be used in addition to Traditional IRAs and Roth IRAs
  • Excess contributions can be carried over and deducted in the following year
  • SEP contributions boost deductions, thereby lowering taxable income. Lowering taxable income results in a lower tax calculation. Thus SEP contributions can be utilized to lower taxes.
  • SEP contributions for self-employed persons are deducted as an adjustment to income.

Adjustments to income will lower adjusted gross income (AGI). Lowering AGI impacts several AGI-sensitive deductions and tax calculations. If you need to lower your AGI to qualify for a particular tax break, SEP contributions can help you do that.

How SEP IRA Contributions Reduce Federal Income Taxes

SEP IRA is funded using pre-tax dollars. The question naturally arises, just how much will a SEP contribution reduce taxes?

And more importantly, which taxes do SEP contributions reduce?

  • For a self-employed person contributing to his or her own SEP IRA, contributions are deducted as an adjustment to income on Form 1040 line 28. SEP contributions reduce a person's adjusted gross income, reduce taxable income, and thereby reduce the federal income tax. SEP IRAs do not impact the calculation of the self-employment tax since the self-employment tax is calculated before SEP contributions are calculated. A self-employed person reduces income tax only by contributing to his or her own SEP IRA.
  • A self-employed person who contributes to SEP IRAs for his or her employees boosts business expenses. This lowers net profit, reducing both the self-employment tax and the income tax.
  • Corporations contributing SEP IRAs for their employees boost business expenses. This lowers net profit, thereby lowering the income tax. Additionally, SEP IRA contributions are exempt from Social Security and Medicare taxes (FICA). Thus an owner-employee does not pay Social Security and Medicare tax on the SEP contributions.

    The following chart summarizes the tax impact at the federal level:

    Type of Business

    Federal income tax

    Social Security tax

    Medicare tax

    Schedule C or F filer contributing to the owner's SEP IRA

    Pre-tax

    No impact

    No impact

    Schedule C or F filer contributing to their employee's SEP IRA

    Pre-tax

    Pre-tax

    Pre-tax

    Partner contributing to his or her own SEP IRA

    Pre-tax

    No impact

    No impact

    Partnership contributing to their employee's SEP IRA

    Pre-tax

    Pre-tax

    Pre-tax

    Corporation contributing to their employee's SEP IRA

    Pre-tax

    Pre-tax

    Pre-tax

    What this chart means is that self-employed persons can reduce their federal income tax, but not their self-employment tax (for Social Security and Medicare), by contributing savings to a SEP IRA. Entrepreneurs running their business as a corporation, by contrast, avoid federal income tax, Social Security tax and Medicare tax on their SEP contributions.

    Other Tax Impacts at the Federal Level

    Indirectly, SEP contributions can reduce other taxes that are calculated based on adjusted gross income or taxable income. This includes the alternative minimum tax and the 3.8% net investment income tax.

    Tax Deferral on Investment Income Earned Inside the SEP IRA

    Like other retirement savings plans, investment income generated on funds inside of a SEP IRA is tax-deferred. That means the interest, dividends, and capital gains earned inside the SEP IRA are not included in a person's annual tax return. Instead, tax is imposed only when money is distributed from the SEP IRA. Tax deferral allows investment income to be re-invested without first paying tax on the earnings. This tax-deferred compounding can result in building up a larger account balance over time.

    Tax deferral also enables a person to move income and corresponding tax liability to some point in the future. By moving income to a future year, a person can control their level of income by deciding when and how much to distribute from the SEP IRA. By controlling the amount of income, a person can more accurately control the amount of tax. Ideally, you'd like to deduct contributions when you're in a relatively high tax bracket and take distributions in the future when you're in a lower tax bracket.

    Taking Advantage of the Setup and Funding Due Dates

    SEP plans can be adopted and funded up to the due date of the tax return, any extensions. This is one of the core advantages of a SEP. Funding a SEP IRA is a way for self-employed persons to boost their deductions for last year by spending money this year.

    This means that self-employed persons filing a Schedule C can set up a SEP and contribute funds to a SEP IRA as late as April 15th, 2015 (without an extension), or October 15, 2015 (with an extension), and have the contributions deducted on their 2014 tax return.

    Consider this scenario: Clare, a self-employed jewelry designer filing a Schedule C, is finishing up her 2014 tax return in September 2015. She filed an extension before April 15th, and so the due date of her return is October 15, 2015. She asks if there's anything she can do to boost her deductions so she can lower her tax liability. Yes, Clare could open a SEP IRA. As long as the SEP plan is adopted and the funds are contributed to her SEP-IRA by October 15th, 2015, she can deduct her contributions on her 2014 tax return.

    By contrast, Clare could fund a solo 401(k) or other retirement plans for small businesses only if she had already adopted the plan in the previous tax year. It's this combination of being able to adopt a plan and fund the plan after the close of the tax year that makes SEP IRAs appealing.

    For business owners and self-employed persons who don't already have a retirement plan, being able to adopt a SEP plan by the due date of the return means they can set up a SEP plan this year and have the plan be effective for last year.

    Being able to fund the SEP IRA by the due date of the return, taxpayers can base their decisions on contribution amounts once all the tax impacts are fully known.

    Another way to take advantage of the funding due date is by spreading out contributions over a longer period of time. This helps the business budget its retirement savings. Funds can be contributed for a specific tax year beginning on January 1 of that year and ending as late as October 15 of the following year. That's a period that spans 21 months and 15 days.

    Taking a Closer Look at SEP IRA Due Dates

    If the business files...

    And didn't file an extension, then the SEP due date is...

    And did file an extension, then the SEP due date is...

    Schedule C or F (Form 1040)

    April 15th following the close of the tax year

    October 15th following the close of the tax year

    Form 1120 (C-corporation)

    March 15th following the close of the tax year

    September 15th following the close of the tax year

    Form 1120S (S-corporation)

    March 15th following the close of the tax year

    September 15th following the close of the tax year

    Form 1065 (Partnership)

    April 15th following the close of the tax year

    September 15th following the close of the tax year

    Contribution Rates Can Vary from Year to Year

    The employer sets a percentage of compensation to be used when calculating how much to contribute to each participant's SEP IRA. The percentage of compensation can range from a low of 0% to a high of 25%. The percentage used must be the same for all plan participants. This percentage can be changed each year, giving the business flexibility in budgeting for retirement benefits based on financial conditions for the year. Business owners have the freedom to contribute more money when financial conditions are good and less money when financial conditions have taken a downturn.

    Participants Control How SEP Contributions are Invested

    Once contributions are made to each participant's SEP IRA, the funds can be managed just like any other individual retirement account. The account holder can decide how to invest the funds, roll over the funds to another IRA, or even take a distribution from the SEP IRA. Distributions from a SEP IRA are taxable and may be subject to a 10% surtax on distributions that take place before age 59 and 1/2.

    Self-employed persons open a SEP IRA with a financial institution of their choice. They can invest their SEP IRA as they see fit. For businesses with employees, the business contributes funds to each employee's SEP-IRA. Each employee is fully vested in the contributions. Employees decide which investments are suitable for their SEP IRA.

    Can You Roll Over a SEP IRA?

    Just like with other individual retirement accounts, SEP IRAs can be rolled over into:

    • A Traditional IRA
    • Another SEP IRA
    • A pre-tax 401(k) plan
    • A pre-tax 403(b) plan

    A SEP IRA can also be converted and rolled over into a Roth IRA.

    Being able to roll over SEP IRAs means that participants are always in full control over where their money is parked and how the money is invested.

    What If You Already Have a Traditional IRA or Roth IRA?

    You can participate in a SEP IRA plan even if you already contribute savings to a Traditional IRA or Roth IRA. Keep these points in mind:

    • Participating in a SEP IRA means that you are covered by a retirement plan at work. This can impact how much can be deducted to a Traditional IRA. The amount of a Traditional IRA contribution that is deductible depends on your modified AGI for the year.
    • Eligibility for Roth IRAs is also based on modified AGI for the year.
    • Self-employed persons can lower their AGI by funding a SEP IRA. Thus it may be possible to lower AGI enough to be eligible for Roth IRAs or deductible Traditional IRAs.
    • Self-employed persons can potentially contribute to a Traditional IRA and/or Roth IRA and/or SEP IRA for the year. This provides flexibility when deciding how much to contribute to each type of retirement plan.

    How to Treat Excess SEP Contributions

    If a person contributes more than the allowed amount to a SEP IRA, the excess amount can be carried over and deducted in the subsequent tax year. However, the excess contribution may be subject to the 10% excise tax for over-contributing to a retirement plan. It's easy enough to avoid over-contributions by performing SEP IRA calculations prior to making any final contributions designated for the tax year.

    How Much Can You Contribute to a SEP IRA?

    There's a maximum dollar limit of $56,000 per participant for tax-year 2019, which is an increase of $1,000 from tax-year 2018. How the contribution amount is calculated depends on whether the plan participant is an employee or is self-employed.

    • For employees: simply multiply the employer's contribution rate (up to 25%) by the annual compensation paid to each employee, subject to the maximum dollar limitation. The employer does not need to report the amount of SEP contributions on each employee's Form W-2. However, the employer will need to check the box on Form W-2 box 13 to indicate the employee was covered by a retirement plan.
    • For self-employed persons: This includes partners in a partnership. Calculating the contribution amount requires measuring compensation and adjusting the contribution rate.

    If you're self-employed, you'll need to measure your compensation for the year by calculating your net earnings from self-employment as follows:

    Net Earnings from Self Employment Calculation

    Start with your net profit from:

    • Schedule C (line 31)
    • Schedule F (line 34)
    • Schedule K-1 (for Form 1065, box 14, code A)

    Subtract the deductible portion of the self-employment tax (Form 1040 line 27)

    The result equals your net earnings from self-employment. To calculate this yourself, use the Deduction Worksheet for Self-Employed found in chapter 5 of Publication 560.

    The second factor is that self-employed persons have a lower contribution rate than employees. This is due to an unfortunate situation in the tax code whereby determining the contribution amount and determining net earnings are mutually dependent on each other. The IRS has devised an indirect method for calculating the contribution amount by adjusting the contribution rate.

    The contribution rate for a self-employed person is calculated as follows:

    • Plan's uniform contribution rate
    • Add 1 to the contribution rate
    • Divide the uniform contribution rate by one the uniform rate. The result is the contribution rate for self-employed persons

    See the Rate Worksheet for Self-Employed in chapter 5 of Publication 560.

    In other words, if a Schedule C filer sets up a SEP IRA with a 25% contribution rate for all participants, the amount that the self-employed person can contribute for his or her employees is 25% of each employee's compensation for the year. And the amount the self-employed person can contribute to his or her own SEP IRA is 20% (that is, 0.25 ÷ 1.25 = 0.20).

    Selected SEP Contribution Rate Conversions

    If Uniform Plan Contribution Rate is: 

    Conversion math

    Corresponding Self-Employed Contribution Rate

    (rounded to 4 decimal places)

    5%

    .05 ÷ 1.05

    4.7619%

    10%

    .10 ÷ 1.10

    9.0909%

    15%

    .15 ÷ 1.15

    13.0435%

    20%

    .20 ÷ 1.20

    16.6667%

    25%

    .25 ÷ 1.25

    20.0000%

    Note: For other conversion amounts, see the Rate Table for Self-Employed in chapter 5 of Publication 560.

    Example: Contribution Calculation for a Self-Employed Person Filing Schedule C

    For a self-employed person, you would multiply net earnings from self-employment by the equivalent self-employed contribution rate to find the contribution amount. Net earnings from self-employment, however, depend on the calculation of the self-employment tax and the deductible part of the self-employment tax. You can see the math in the following example.

    Clare is a self-employed jewelry designer filing a Schedule C. She has no employees, and so needs to calculate a SEP IRA contribution only for herself. She wants to find out the maximum amount she could contribute to a SEP IRA. Here's how she would come up with the answer.

    Clare would start with her net profit of $100,000, which would be found on line 31 on her Schedule C. She would then perform the self-employment tax calculation (using the Short Schedule SE method) as follows:

    Multiply net profit from Schedule C, line 31 by 92.35%

    $100,000 × 0.9235 = $92,350

    Multiply the result by 15.3%  (this is the self-employment tax)

    $92,350 × 0.153 = $14,129.55

    Divide the result by 2 (half of self-employment tax is deductible)

    $14,129.55 ÷ 2 = $7,064.78

    Net earnings from self-employment:

    $100,000 – 7,065 = $92,935

    Uniform Contribution Rate

    25%

    Convert to SE Contribution Rate

    25% ÷ 125% = 20% or .20

    Multiply net earnings by the SE Contribution Rate:

    $92,935 × 0.20 = $18,587

    In this example, Clare could contribute up to $18,587 to her own SEP-IRA based on the $100,000 of net profit on her Schedule C. She could contribute less if she wanted. Notice this amount is not 25% of her Schedule C, nor is it even 20% of her Schedule C.

    To calculate your own SEP IRA contribution amounts, use the Deduction Worksheet for Self-Employed found in chapter 5 of Publication 560.

    Things to Consider Before Adopting a SEP

    • Read over chapter 2 of Publication 560. The IRS has done a very good job of explaining simplified employee pension plans.
    • Read the model SEP plan (Form 5305-SEP) or similar model plans offered by the financial institution of your choice.
    • If your business has employees, evaluate which employees must be covered by the SEP plan (detailed in Publication 560).
    • Review what disclosures must be made to employees (also detailed in Publication 560).
    • Understand how much you can potentially contribute to a SEP IRA.
    • Understand how contributions will be deducted on the tax return, and how it impacts your tax calculations.
    • Compare the SEP against other small business retirements plans such as 401(k) and SIMPLE plans.
    • Research financial institutions that administer SEP IRA plans. Review the financial institution's paperwork, costs, and investment options.
    • Consult with a tax professional for help in comparing the impacts of each type of plan.

    Resources from IRS.gov

    • Publication 560, Retirement Plans for Small Business )
    • Form 5305-SEP, model SEP plan )
    • SEP Plan Fix-It Guide (identifies 6 mistakes and how to fix them)
    • SEP Plan FAQs
    • Choosing a SEP Plan
    • Establishing a SEP Plan
    • Participating in a SEP Plan
    • Operating and Maintaining a SEP Plan
    • Terminating a SEP Plan
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