Self-Employed? Consider a SEP IRA Plan

Take-Away: Many Americans are not fully retiring when they start to take social security. Instead, they may continue to work part-time, or as an independent contractor to add to their social security retirement income. Alternatively, individuals may have their own business on the ‘side’ to supplement their earnings while working for an employer. A Simplified Employee Pension (SEP) IRA is one way to continue to defer income taxes on that ‘side’ income while continuing to save for retirement. However, like all of the Tax Code with regard to IRAs, a SEP IRA comes close, but is not always treated the same as a traditional IRA.

Background: A Simplified Employee Pension (SEP) is an IRA. [IRC 408(k).]It is an employer sponsored retirement plan to which contributions are made to the employee’s IRA. Contributions are income tax deductible by the employee or the employer’s business. If the individual is self-employed, the individual is considered to be the employer who establishes the SEP IRA. Only the employer contributes to the SEP IRA, however. Once the funds are in the SEP IRA they are treated like any other traditional IRA, subject to all of the rules that apply to a traditional IRA, which tends to distinguish a SEP IRA from a qualified plan sponsored by the employer. Examples: (i) a distribution can be taken from the SEP IRA at any time, not so with a qualified plan account; (ii) no loans can ever be taken from the SEP IRA, but loans may be permitted from a qualified plan account.

SEP IRA Advantages: The advantages to a SEP IRA include:

Contributions up to $56,000: One critical advantage to fund a SEP IRA over a traditional IRA, or even a Roth IRA, is a higher annual contribution limit. For 2019, a SEP IRA contribution limit is 25% of the employee’s compensation up to $280,000, limited to a maximum annual contribution to the SEP IRA of $56,000. There are special, albeit complicated, rules that apply to calculate how much a self-employed individual can contribute to his/her SEP IRA.
Multiple Plan Participation: Even if the individual participates in a qualified retirement plan at another job e.g. 401(k) account, he/she can still fully fund their SEP IRA from their part-time employment or self-employed activities.
Timing of Deductible Contribution: A SEP IRA contribution can be made up until the due date of the individual’s income tax return, including extensions, i.e. October 15 of the following calendar year. Contributions to the SEP IRA are not required to be made each year, which is helpful if part-time employment comes and goes from year to year, or the earnings from that part-time employment varies from year to year.
Dual Contributions: If an individual wishes to contribute to both a traditional IRA and a Roth IRA (and who meets other eligibility requirements) he/she may contribute to either the traditional IRA, or Roth IRA, or to both, provided that the total contributed to both accounts for the year may not exceed the lesser of that year’s reported applicable dollar limit or the individual’s compensation for the year. Contributions made on the individual’s behalf to a SEP IRA are ignored for this contribution limitation, as they are considered employer contributions and consequently they have no effect on the maximum the individual may contribute to his/her own traditional IRA or Roth IRA.
Post-Death Contributions?: The IRS has held that a personal representative cannot contribute to a traditional IRA on behalf of the deceased IRA owner. [PLR 8439066.] However, there might be a different rule for SEP IRAs. In the IRS’ Publication 560 with regard to Retirement Plans for Small Businesses the Service notes: “But if you make contributions…you must contribute to the SEP-IRAs of all participants who actually performed personal services during the year for which the contributions are made, including employees who die or terminate employment before the contributions are made.” Consequently, this might provide an opportunity for some income tax planning on behalf of a SEP IRA owner who dies.

SEP IRA Limitations:

ERISA: because a SEP IRA is an employer-funded plan, it may be subject to some ERISA requirements that generally do not apply to traditional IRAs.
No Qualified Charitable Distribution: An IRA owner can satisfy part, or all of his/her required minimum distribution (RMD) obligation by making direct distributions from their traditional IRA to charities, using a qualified charitable distribution, or QCD. This is an important planning opportunity, since the funds directed to the charities satisfy the owner’s RMD for the year, while they are not reported in the owner’s taxable income for the year. The upshot is that a qualified charitable distribution (QCD) from a traditional IRA is the equivalent to a 100% income tax deduction for the year. Only traditional IRAs can be used for this purpose [recall that Roth IRAs have no RMD requirements so they are seldom used for QCDs.] A SEP IRA can be used to make a QCD but only if that SEP has not received any contribution for that calendar year. In short, old and stale SEP IRAs that no longer receive contributions can be used as a source for QCDs, but not if contributions have been made to the SEP IRA for that year. [IRS Notice 2007-7, A-36.]
No Salary Deferrals: Salary deferrals are not permitted to a SEP IRA, unlike a 401(k) account.
No ‘Catch-up’ Contributions: Similarly, ‘catch-up’ contributions are not permitted to a SEP IRA if the employee is over age 55 years, unlike a traditional IRA.
Phased-out Tax Deduction: If the individual employee wants to fully fund a traditional IRA and also a SEP IRA, the income tax deductibility of the contribution will phase-out at higher compensation levels.

Conclusions: As many individuals approach retirement age, and they consider continuing to work part-time, or as independent contractors, or they intend to start side-businesses to supplement their retirement income, those individuals should consider opening a SEP IRA to complement contributions to their traditional IRA and to defer income taxes.