A brief explainer on SEP-IRAs, something like a 401k for self-employed people (and side hustlers!)
As a W-2 employee, I did a pretty good job contributing to my 401k, but decided to take a leap into the world of 1099 subcontracting. I knew I wanted to keep the retirement momentum going but wasn’t sure how. It’s a somewhat common arrangement in my field…one spouse works W2 for the healthcare benefits, and the other spouse does 1099 hourly work to maximize income without all the overhead and expenses a big company might be taking out of your bill rate. This actually can apply to any 1099 income, not just “full time” or traditional self-employment (Uber driving, DoorDash, any of the ‘gig economy’ type work). As long as it’s reported to the IRS on a 1099-MISC, you’re eligible to use it for SEP-IRA contributions. Consider it a (simpler!) 401k for the self-employed.
SEP-IRA Fast Facts
- Stands for “Simplified Employee Pension Plan” – and it actually is simple!
- Dead simple to set up and administer, just call/log on to Vanguard or any number of other brokerages (Fidelity, ETrade, etc.)
- Contributions are Pre-Tax (meaning any contributions you make will reduce your taxes because it’s reducing your ‘taxable income’
- Does not have the limits of a Roth or Traditional IRA, you can contribute up to 25% of self-employment income or $58,000, whichever is less [see below]
- Generally speaking, you can’t touch the money until age 59½ (FIRE exceptions exist!) [see below]
- Any contributions you make for yourself you must also make for any employees! [see below]
- You have a few months into the calendar year to make contributions for the previous year and lower your taxes before April 15th! [see below]
SEP-IRA vs 401k
A 401k is a retirement plan typically offered by a company to their W2 employees. You contribute a portion of your income (pre-tax) and your employer will usually match up to a certain percentage. Your employer’s plan will generally have a few pre-selected investment options, generally with higher fees than those you might choose on your own. Plans frequently have rules in place to allow 401k loans. With a SEP-IRA for a self-employed person, you can choose whatever funds are available in the brokerage you use to set it up, and you can make both employer & employee contributions up to a certain limit. There are other types of accounts that are functionally very similar to this (TSP, 403b), so just assume when I say “401k” the same things apply to a 403b, TSP, etc.
How Much Can I Contribute to a SEP-IRA?
That depends! Because there a lot of ways unscrupulous people could use this simple account to do shady stuff, the IRS sets some parameters to try to reign in shenanigans. The short version is “$58,000 or 25% of self-employment income, whichever is less.” The easiest way to max it out if you’re on a side hustle or get irregular 1099 income (like a realtor working solely on commissions) would be to just contribute 25% whenever you get a check. Let’s run a few example scenarios:
Scenario 1: Part-time Uber driver
Alex drives Uber on weekends and makes about $300 in a weekend and goes out almost every week. He had 1099-MISC income of $14,400 last year. Alex can contribute $3,600 (because 14400x.25 is 3600).
Scenario 2: Crazy Hustlin’ DoorDash Driver
Mariela delivers for DoorDash, and treats it like a full-time job. She’s out there for 8+ hours a day, 5 days a week. She had 1099-MISC income of $26,000. She can contribute $6,500 (because 26000x.25=6500).
Scenario 3: Self-Employed Software Developer
John has a few contracts with big firms that each pay $100/hr for a total of 2,000 hrs/yr. He can contribute $50,000 (because 200,000x.25=50,000).
Scenario 4: Yoga Teacher to the Stars
Andrea teaches yoga to a bunch of rich celebrities. They pay her $10,000 week to hold classes on their yacht. She can contribute $58,000 (because 25% of her income would be $130k and the rules say you can contribute 25% or $58,000, whichever is less).
These limits are the *employer* contributions, but you can also make up to $6,000 in contributions as an employee (total of $6,000 combined across any Traditional/Roth/SEP IRAs).
Plan on not touching this money until retirement
While a lot of 401k-type plans have provisions where you would be allowed to take a loan without penalties (say, for a down payment on a house), that is not possible with a SEP. Withdrawals before the age of 59½ are generally subject to a 10% penalty, plus you’ll owe taxes on the amount. While there are some exceptions to this that you’d need to research in the event of an emergency, that’s outside the scope of this blog. While a SEP can be thought of as a 401k for the self-employed, there is a little less flexibility on withdrawals than with employer-sponsored 401ks.
One notable exception I’ll mention here is the SEPP (no relation), or “substantially equal payment plan.” Basically, if you hit your FIRE number before age 59½ but you want to use your tax-advantaged retirement accounts to buy that beachfront condo, there is a complicated plan you can set up to basically pay yourself an annuity out of the IRA. Way more complex than we’re going to get into here, but worth mentioning in case you think “I want to retire early, I’m not going to set up a SEP-IRA because I can’t wait til I’m 59!”
Caveat: Do unto others…
One major caveat here: Any contributions you make for yourself, you must also make for any employees. There are particulars about this you should investigate or enlist professional help with, but be aware of it! In my case, I have no employees. If I did, and I wanted to put $30k/year into my SEP, I would also have to put $30k/yr into theirs. That might be desirable or advantageous for a family business where it’s all spouses and kids on the payroll, but I’ve never actually heard of an employer doing it for their employees.
It’s not too late to reduce last year’s tax bill!
At the time I’m writing this, taxes for 2020 aren’t due until April 15th. Although I have weekly contributions set up into my SEP-IRA throughout the year, I still had a bit of “cap space” on my contribution limits. So the last week in March, I was able to put an additional $10,000 towards my SEP-IRA for 2020, which reduced my tax bill for 2020 by $2,500! Looking at that another way, it only cost me $7,500 to put away $10k! Free and immediate 25% return, you’re not going to find that in any hedge fund!
The Takeaways
If you have self-employment income, but *especially* if it’s your main source of income, you should absolutely consider opening and funding a SEP-IRA with as much money as you can. It has two major benefits: Reducing your tax bill, and building your retirement “nest egg.” A 401k for the self-employed, and *you* get to pick the funds you’re investing in!