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Use a SEP IRA to Save for Retirement and Reduce Taxes

If this is going to be a good year financially for your small business and you think you will pay too much in taxes due to that success, setting up a retirement plan could reduce your tax bill and put you on the right path for retirement.

As a small business owner, your business is typically set up in one of two ways: You may be established as an independent contractor or 1099 employee, which is typical in some service businesses, or you may be a corporation. Small businesses set up as corporations are very often S corporations. Under either circumstance, you can take advantage of setting up a retirement plan that will lower your tax burden while putting money away for your financial future.

Simplified Employee Pension (SEP) IRA

Retirement plans can be set up and funded by a small business regardless of their business structure. However, the type of plan, the amount you can contribute, and your overall tax deduction may differ based upon your structure. The SEP IRA is one of the most popular options that is available.

The SEP IRA allows a business owners who pay themselves via a W-2 to defer a maximum of 25% of their income into the retirement plan each year, which will lower your tax liability. This is the least common payment method for independent contractors. Business owners using a Schedule C to determine their income for the year (most common for 1099 employees) can contribute up to 20% of their net income. Schedule C or 1099 employees are treated the same for retirement plan purposes. (For related reading, see: Who's required to fill out a Schedule C IRS form?)

Contribution Limits

Whether you are limited to 20% or 25%, the maximum dollar amount you can contribute for 2018 is $55,000. This amount changes annually. Visit the IRS website for current limits. Keep in mind, a SEP IRA simply needs to be set up and funded before your tax filing deadline. The contributions are not mandatory and can change from year to year based on your annual success. This gives you a lot of flexibility and plenty of time to review your year-end tax situation prior to contributing. 

For example, if you are an independent contractor in the 25% tax bracket who had a net income of $200,000 and set up a SEP IRA, You could contribute up to $40,000 (20% of your net income). This would lower your taxable income from $200,000 to $160,000, which means your tax bill would be reduced by $10,000. Essentially the $40,000 contribution made to your SEP IRA will only cost you $30,000.

The SEP IRA works the same way for those businesses set up as corporations. The only difference is they will be able to contribute 25% of their W-2 wages. Keep in mind that you if you are paying yourself via a W-2, you can only include the W-2 wages when determining your maximum contribution. Shareholder distributions are not included as compensation when calculating your SEP IRA contribution.

If you have employees, this may not be the best option because you will be required to contribute for those who have been with you three years or more. The percentage used to determine your contribution would be used for your employees as well, which may create a financial burden. For some business owners, though, a SEP IRA is a great strategy to alleviate tax burdens during successful years while also saving for retirement.

(For more from this author, see: When You Start Saving for Retirement Matters.)


Disclosure: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.