Are you newly self-employed? Welcome aboard, but it’s important to understand the tax implications. For the basics on that, see my earlier column on what to know about taxes if you’re thinking about becoming your own boss.
In this column, let’s focus on setting up a tax-saving retirement plan. You need to know your options. Here’s Part 1 of the story.
Key point: Self-employed means a sole proprietor; the sole owner of a single-member limited liability company (LLC) that’s treated as a sole proprietorship for tax purposes; a partner; or a member of a multi-member LLC that’s treated as a partnership for tax purposes. If you meet one of those descriptions, this column is aimed at you. Read on.
The Simplified Employee Pension (SEP) option
SEPs are stripped-down retirement plans mainly intended for self-employed individuals. In effect, a SEP is a defined-contribution plan. As such, the maximum deductible contribution for the 2022 tax year is $61,000. But your contribution is limited to 20% of net self-employment (SE) income reduced by the deduction for half of your self-employment tax (SE tax).
So, the maximum deductible SEP contribution for the 2022 tax year is the lesser of: (1) $61,000, or (2) 20% of net SE income from Schedule C of your Form 1040 or Schedule K-1 if you’re a partner or an LLC member treated as a partner reduced by the deduction for half of your SE tax.
What’s good about Simplified-Employee Pension plans
* If you have a healthy amount of SE income, you can make large annual deductible SEP contributions — potentially up to $61,000 for the 2022 tax year. Nice. That said, you would need at least $305,000 of net SE income to claim the maximum deduction (20% x $305,000 = $61,000). I hope you get there.
* With a SEP, there is no requirement to contribute anything for a particular year. So, in years when cash is tight, you can contribute a small amount or nothing. In years when you’re flush, you can contribute the maximum allowable amount.
* For a one-person business, a SEP is extremely simple to set up at your friendly brokerage firm or financial institution. The required paperwork (IRS Form 5305-SEP) can be completed in about five minutes. Honest.
* You can establish a SEP and fund the account as late as the extended due date of the Form 1040 for the year in which the initial deduction is claimed. For example, if you’re a sole proprietor who extends your calendar-year 2022 Form 1040 to 10/17/23, you have until that date to establish the SEP and make the initial contribution, which you can then deduct on your 2022 Form 1040. On the other hand, you can establish and fund your SEP anytime between now and then if you extend your 2022 return.
* Once your SEP is established, there are essentially no administrative details to worry about. There’s generally no need to incur the expense for professional assistance.
What’s not so good about SEPs
* If you have one or more employees, annual employer SEP contributions may be required for any employee who: (1) is at least age 21, (2) has worked for you during at least three of the past five years, and (3) receives at least $650 of compensation. Since all employer contributions vest immediately, an employee can hit the road at any time without losing any of his or her SEP money. That would not make you happy. For that reason, SEPs are generally not a great idea for businesses with more than a few beloved employees — although there is no tax-law restriction on the number of employees. Contributions on behalf of employees are, of course, deductible by you as the employer.
* As we will explain, some other types of plans may permit larger contributions, depending on your circumstances.
When SEPs make the most sense
Because of their simplicity and flexibility, SEPs are often the best choice when only you, the self-employed business owner, will be covered by a tax-advantaged retirement plan.
The SIMPLE IRA option if you only have modest SE income
As a self-employed small business owner, you also have the option of setting up a SIMPLE IRA plan. For the 2022 tax year, you can make a deductible contribution of up to $14,000 of net SE income to your SIMPLE IRA account. In addition, you can make a so-called matching contribution of up to 3% of SE income.
Example 1: You will have $40,000 of 2022 net SE income. You can make combined deductible contributions of up to $15,200 for the 2022 tax year: $14,000 + $1,200 matching contribution (3% x $40,000). In contrast, the most you could contribute to a SEP would be only $8,000 (20% × $40,000).
For the 2022 tax year, an additional “catch-up” contribution of up to $3,000 is allowed if you will be age 50 or older as of 12/31/22.
Example 2: Same as Example 1 except you’ll be 50 or older by yearend. You can make combined deductible contributions of up $18,200 for the 2022 tax year: $14,000 + $1,200 matching contribution + $3,000 catch-up contribution. The most you could contribute to a SEP would be only $8,000.
What’s good about SIMPLE IRAs
* When you have only a modest amount of net SE income, the maximum deductible contribution to a SIMPLE IRA may be considerably larger than what would be allowed under the other tax-advantaged retirement plan flavors.
* Like with a SEP, contributions to a SIMPLE-IRA are completely discretionary. In years when cash is tight, you can contribute a smaller amount or nothing. In years when you’re flush, you can contribute the maximum allowable amount.
* You can establish a SIMPLE IRA by filling out a fairly easy plan document available at your friendly brokerage firm or financial institution.
* You need not file any annual reports with the government.
What’s not so good about a SIMPLE IRA
* You must set up a SIMPLE IRA by October 1 of the year for which you want to make your initial deductible contribution. So, if you want to make a contribution for the 2022 tax year, you’ve got to make your move by no later than 10/1/22. However, the contribution itself can be made as late as the extended due date of your 2022 Form 1040.
* If you have employees, contributions may have to be made for them, and those contributions become 100% vested immediately.
* Other types of plans allow larger annual deductible contributions to your account if you have lots of SE income. For instance, with a SEP you could contribute up to $61,000 for the 2022 tax year if you have net SE income of $305,000 or more this year.
When a SIMPLE IRA is best
If you want to maximize annual deductible contributions, a SIMPLE IRA can be considerably the best retirement plan option when your business generates only a modest amount SE income. If you’re age 50 or older, you can make additional catch-up contributions to sweeten the tax-saving deal.
The bottom line
The SEP and SIMPLE-IRA retirement plan options are the two simplest and easiest ones on the books. Other things being equal, simple is good.
In my next column, I’ll explain two more-complicated retirement plan options that can allow bigger annual deductible contributions if you have lots of SE income and don’t mind putting lots of cash into your retirement account where it’s beyond your immediate reach. Please stay tuned.