• Any investment income earned inside the SEP-IRA is tax-deferred.

• The contributions can be made after the end of the tax year.

• Participants have control over how the contributions are invested.

• The remaining fund can be rolled over to traditional IRAs.

• The plan can be utilized in addition to traditional IRAs and Roth IRAs.

• Excess contributions can be carried over and deducted in the following year.

• SEP contributions increase deductions, thus lowering taxable income (which then results to lower tax calculation).

• SEP contributions for self-employed persons are subtracted as an adjustment to income.

Income adjustments lower AGI (adjusted gross income) which is impacting to numerous AGI-sensitive deductions and tax calculations. SEP contributions helps to qualify for a particular tax break since it lowers the AGI.

Funded using pre-tax dollars, a SEP IRA can reduce tax liabilities in explicit ways.

Self-employed individual contributing SEP IRA for himself: When a self-employed person contributes to his own SEP IRA, these contributions are deducted as an adjustment to income on Form 1040, line 10a, using Schedule 1. When an individual’s AGI is reduced through SEP contributions, the taxable income is reduced as well (and so is the federal income tax). The self-employment tax is not impacted by SEP contributions because that is computed prior to the calculation of SEP contributions. So a self-employed individual reduces income tax merely by contributing to his own SEP IRA.

A self-employed individual contributing to the SEP IRAs of his employees: When a small business owner contributes to his employees’ SEP IRAs, his business expenses are boosted which result to lower net profit, thereby reducing both the employment and income tax.

In addition to the mentioned tax benefits, SEP IRA contributions are exempt from FIC (Social Security and Medicare taxes). This means that the employer-employee does not pay FICA on the SEP contributions.

SEP contributions can indirectly reduce other taxes that are computed based on AGI or taxable income (including the AMT or alternative minimum tax and the 3.8% net investment income tax).

Just like in any other retirement savings plans, the investment income produced on funds inside the SEP IRA is tax-deferred. Given this, the interest, dividends, and capital gains generated inside the SEP IRA are not included in an individual’s annual tax return. Tax is merely imposed when money is allocated from the SEP IRA. Investment income can be reinvested without needing to pay tax on earning first since it is tax deferred. These tax-deferred computing results to the accumulation of a larger account balance over time.

With this tax deferral capability, an individual can move income and its corresponding tax liability to a future time. Moving income to some point in the future can give the individual control on the level of income by deciding on the schedule and amount of distribution from the SEP IRA. Such control on the income amount allows an accurate control of the tax. Preferably, individuals would like to deduct contributions when he is on a relatively high tax bracket and take distributions in a future time when he belongs to the lower tax bracket.

SEP plans can be funded and adopted until the tax return’s due date (extensions are granted). What is notable about SEP is that funding it gives self-employed individuals to increase their deductions for last year by spending money on the current year. A self-employed individual who is filing a Schedule C can set up a SEP and contribute funds to a SEP-IRA as late as April 15th (no extension is allowed), or October 15 (with an extension), and have the contributions subtracted on their tax return for the previous calendar year.

Those who do not have a retirement plan yet, a SEP plan can be set up for the current year and make it effective on the last tax year. If SEP IRA is funded by the due date of the return, the contribution amount can be decided once all the tax impacts are sufficiently known.

Contributions can also be spread out over a longer period of time to take advantage of the funding due date as a way for businesses to budget their retirement savings.

Funds can be contributed for a particular tax year starting on January 1 of that year and ending as late as October 15 of the next year (total of 21 months and 15 days).

Sample Scenario:

Anna is a self-employed fashion designer who is filing a Schedule C and is completing her tax return in September. She requested an extension prior to April 15 (the due date of her return is October 15). To increase her deductions (she aims to lower her tax liability), she opened a SEP IRA. Given this scenario, Anna can deduct her contributions on her tax return for as long as the SEP plan is adopted and funds are contributed prior to or on October 15.

Anna, in contrast, could fund a solo 401(k) or other retirement plans for small businesses if she has adopted the plan in a previous tax year. This makes SEP IRAs appealing because it can be adopted and funded after the close of the tax year.

For employees: The employer’s contribution rate (up to 25%) is multiplied to the annual compensation paid to each employee (subject to maximum dollar limit). How the contribution amount is calculated depends on whether the plan participant is an employee or self-employed. Employers are not required to report the SEP contributions on each employee’s Form W-2. But the check box on Form W-2 box 13 should be checked to specify that the employee is covered by a retirement plan.

For self-employed individuals: Including partners in a partnership, computing for the contribution amount requires assessing of the compensation and adjusting of the contribution rate. Compensation is measured for the year by calculating the net earnings from self-employment.

• Net Earnings Calculation from Self-Employment: Net profit should start from Schedule C (line 31), Schedule F (line 34), Schedule K-1 (for Form 1065, box 14, code A). Then subtract the deductible portion of the self-employment tax (Form 1040, line 22). The difference is the net earnings from self-employment. The Deduction Worksheet for Self-Employed (Chapter 5 of Publication 560) is used to compute for this. Take note that self-employed individuals have a lower contribution rate as compared to that of the employees. Based on the tax code, the contribution amount and net earnings are mutually dependent on each other. The IRS has developed an indirect way for computing the contribution amount by adjusting the contribution rate.
• Contribution Rate Calculation for a Self-Employed Individual: 1. Start with the uniform contribution rate of the plan, 2. Add 1 to the contribution rate, 3. Divide the uniform contribution rate by one plus the uniform rate. The result of this is the contribution rate for self-employed individuals. If a filer for Schedule C sets up a SEP IRA with a contribution rate of 25% for all plan participants, the amount that can be contributed for employees is 25% of each employee’s compensation for the year. This means that the self-employed person can contribute 20% for his own SEP IRA (25 ÷ 1.25 = 0.20).

Note: See the Rate Table for Self-Employed in chapter 5 of Publication 560 for other conversion amounts.

1. A written agreement is the primary requirement to initiate the SEP IRA. This may include Form 5305-SEP and SEP IRA contribution agreement.  Both can be easily accessed on the IRS website.  In such instances, financial institutions can also offer approved prototype SEPs.
2. Qualified employees should be given details of the SEP. This may include the agreement as well as the instructions.  Such info that the employees should be given are:

• All amendments to the retirement plan will be handed out by the SEP administrator within 30 days from the date that it was implemented.
• Participating employees will receive a report of the contributions made by the employer every 31^st of the next year.

3. Employees who are eligible should have their own SEP IRA account set up. We’ve known that these employees are already 21 years of age or above, earn $600 or more in the present year, and already worked for the company for a minimum of three years of the past five years. The SEP IRA of the employees can be established through any financial institution.  Automatically, the employee is 100% vested in contributions through his or her employer.
4. Employers can also fund and create a new SEP retirement plan until the filing of tax returns.

Before the age of 59 ½, distributions from a SEP-IRA are taxable and may be subject to a 10% surtax on distributions that take place.

Self-employed individuals can also choose the financial institution where they want to open the SEP IRA and invest their funds as they see fit.

Employees who are granted SEP IRA by their employer is fully invested in the contributions and can decide which investments are fit for their SEP IRA.

• With SEP IRA, you are covered by a retirement plan at work which has an impact on the amount that can be deducted for a Traditional IRA. The modified AGI for the year determines the amount of a traditional IRA contribution.
• Roth IRA eligibility is based on the individual’s modified AGI for the year.
• Through funding a SEP IRA, self-employed individuals can lower their AGI which can make them eligible for a Roth IRA or a deductible traditional IRA.
• Self-employed individuals can possibly contribute to a traditional IRA and/or Roth IRA and/or SEP-IRA for the year giving them the flexibility to decide on the amount that they will contribute to each retirement plan type.

There is no shortcut to knowing which one will work just right for your company.  So, before you hop in the world of SEP, equip yourself with all the knowledge by digging into the options available and types of plans.  We are your friendly neighborhood when it comes to SEP.  Give us a call if you would like to learn more or know what options you have.

• Review Publication 560 Chapter 2 for the IRS’ detailed explanation of simplified employee pension plans.
• Review the model SEP plan (Form 5305-SEP) or comparable model plans that is offered by your chosen financial institution.
• Assess who among your employees must be covered by the SEP plan (eligibility information are detailed in Publication 560).
• Evaluate the disclosures that should be made to employees (also detailed in Publication 560).
• Review the contribution amount that you can potentially make to SEP IRA.
• Review how contributions will be deducted on the tax return and how that it will impact your tax calculations.
• Review the comparison and difference of SEP against other small-business retirement plans, such as 401(k) and SIMPLE plans.
• Explore financial institutions that manage SEP plans and review their paperwork, costs, and investment options.
• Consult with a tax professional like Credo to gain a better understanding of the impacts of each plan.