Meeting with a client to discuss a SEP retirement plan.

Why SEP plans are a great option for the self-employed

Whether you call them freelancers, independent contractors, solopreneurs, independent workers, consultants, small business owners or participants in the gig economy, the self-employed are a growing part of the U.S. labor force. In fact, Brad Smith, CEO of Intuit®, estimates they make up 34 percent of today’s workforce and will expand to 43 percent by 2020. Today’s freelancers and independent workers are also financially successful, with one in five earning more than $100,000 per year.

Without a 401(k) plan from a traditional job, your self-employed clients are on their own to save for retirement. They need a flexible plan that enables them to quickly accumulate funds and save on taxes. A Simplified Employee Pension (SEP) plan is a great option.

SEP plans are a type of IRA with higher contribution limits than other IRAs. For 2017, SEP contributions are limited to the smaller of 25 percent of compensation, or $54,000. In 2018, the limit increases to $55,000. By comparison, either a traditional or Roth IRA only allows contributions of $5,500 for those under age 50 and $6,500 for those over age 50. Contributions to traditional and Roth IRAs are subject to phaseouts based on income and filing status. The high contribution limit for a SEP plan lets your clients shield a good chunk of income from current year taxes and accumulate a healthy retirement fund.

These plans are great for procrastinators because they can be set up and funded up to the due date of their tax return, including extensions. All that’s required is filling out Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement, and providing it to the investment company that will serve as trustee and setting up the account. No other annual reporting or filing is needed. Contributions are discretionary, so in lean years, clients can contribute less, or not contribute at all.

For S-corporations, the compensation base is the salary paid to the owner, and the SEP contribution is deducted on the S-corporation return. The contribution calculation is a bit more complicated for sole proprietors or partners in partnerships. The compensation base is the net earnings from self-employment reduced by the deductible portion of self-employment taxes and their SEP contribution. Fortunately, tax software makes this circular calculation easy by just selecting the option to calculate the maximum SEP contribution. For these clients, the SEP contribution is deducted on their personal tax return.

If your clients were making monthly contributions to their SEP IRA – a good habit to encourage – you can find out how much they can still contribute when you prepare their tax return. If they’ve contributed too much, this can be corrected by contacting their investment advisor and either withdrawing the excess contributions or re-characterizing the excess as contributions for the following year.

If your clients’ businesses grow and they hire employees, they’ll have to make contributions for eligible employees at the same percentage of compensation for everyone. To be eligible, an employee must be:

  • over 21 years old,
  • receive $600 or more in compensation and
  • have worked for that employer for three of the last five years.

In these cases, your clients can set up less restrictive requirements, but can’t have anything more restrictive. Contributions must be made for all eligible employees who worked for your clients at any time during the year, not just those still employed at year-end.

All contributions to SEP plans are made by the employer and all contributions vest immediately. These characteristics make it a great plan for family businesses that employ spouses or children. If your client has employees, they’ll need to provide a copy of Form 5305-SEP to each employee and set up an IRA account for each of them.

For those who want to keep working, contributions can still be made after age 70 ½, although they will also have to take Required Minimum Distributions.

All of these qualities make SEP plans a great option for the self-employed. The higher limits and flexibility of contributions allow your clients to put away more in good years and save cash in lean years.

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