One of the coolest things I’ve discovered about making money on the side and taxes is that I have the option to contribute to yet another tax-deferred retirement savings plan – the SEP IRA!
What’s so great about it? Not only do I get to save more money above and beyond the maximum limits of what I’m already saving in my 401k and Roth IRA, but it also accomplishes one VERY important task – saving me a boat load of money on the amount of taxes we owe for the year on our Federal return!
2016 will be no different. With all of the income we’ve earned from blogging last year, I’m going to end up contributing close to $3,000 this year to my Vanguard SEP IRA. At an estimated 28% tax bracket, that means I’ll be saving myself over $800 in unnecessary tax payments I would have had to hand over to the IRS this year!
If you’re a money-making blogger or even someone with a hobby that earns them some extra income on the side, then you’ll definitely want to read on and see how you can save yourself potentially thousands of dollars in taxes this year.
What is a SEP IRA?
Chances are that unless you’re self-employed (or really into personal finance strategies like I am), than you’ve probably never heard of a SEP IRA.
A SEP IRA is short for a “Simplified Employee Pension Individual Retirement Arrangement”. Basically it’s another style of retirement plan designed for people who are either work for themselves or have a very small number of employees.
Keep in mind: You can be both employed by someone else AND self-employed. My situation is a good example of this. I earn a regular salary from my day-job and from blogging. Therefore I am both.
Without getting carried away on the technicalities, you can think of a SEP as the same thing as a regular traditional IRA. They carry the same rules for deductions, tax-sheltered investment growth, investment options, and no early withdrawals until age 59-1/2. However, there’s one BIG difference to note: You get to contribute to a SEP IRA as two different people, 1) the employee and 2) the employer.
The employee part.
Contributing to your SEP IRA as an employee is really no different than when you contribute to your regular IRA. You can invest up to $5,500 for the year in ANY combination of the IRA’s you choose.
Example: If you wanted to put $3,000 in a Roth IRA and $2,500 in a SEP IRA (as an employee), you could do so. Since I already max out my Roth IRA every year, my SEP IRA employee portion is $0.
The employer part.
Now here’s where it starts to get interesting!
Because you’re declaring business income (from your blog, freelancing, whatever) on your tax filing, the government treats you like you’re self-employed (again, even if you’re also a full-time employee for someone else).
Therefore, as your own employer in this regard, the IRS says that you have the opportunity to pay yourself a nice big bonus to put towards your retirement savings.
How much exactly? Employer SEP IRA contributions can’t go over the lesser of:
- 25% of the employee’s total compensation. (Note: If you’re like me, the actual math works out to 20% of your Adjusted Profits. I’ll show you can easily calculate this yourself in the section below.)
- $53,000 for the 2016 tax year.
How This Ends Up Saving You Money in Taxes:
If you’ve been questioning up until now how this is all supposed to benefit you, here is the part you were waiting for: Your SEP IRA employer contributions are deductible as a business expense.
Basically that’s like saying if you made $20,000 last year, you could choose to pay taxes on the whole $20,000 OR you could give yourself $4,000 for retirement and only pay taxes on the remaining $16,000.
Which one would you rather do: Pay the government or keep more of your hard-earned money for yourself?
I know which one I prefer …
Just in case you’re feeling curious, here’s an example of how to actually calculate how much you could stash in a SEP IRA according to how the IRS calculates it. Fidelity has a good worksheet that helps guide you through the steps that you can download here.
Suppose your profits for the year were $20,000 after you subtract away Self-Employment Tax.
Take $20,000 divided by 1.25 = $16,000.
Then take $16,000 x 0.25 = $4,000.
There you have it! $4,000 is what you get to contribute to your SEP IRA for the year.
(Mathematically this also works if you simply go $20,000 x 20% = $4,000. But who am I to argue with the way the IRS does things?)
If you’re in the 25% tax bracket, that’s $4,000 x 0.25 = $1,000 you just saved in taxes!
My Vanguard SEP IRA:
I think anyone that reads this blog knows that I always prefer to deal with Vanguard over pretty much everyone else. However when it comes to my SEP IRA, they go ahead and get some extra credit.
It was actually a phone call with Vanguard’s customer service where I first learned about my eligibility to contribute to one. Not only did they explain how one works and the rules for contributing to one, they also let me know that the account is completely free of administration costs.
Again this year I’m happy to make another big contribution to my Vanguard SEP IRA and watch it grow even further. I invest very simply using my favorite low-cost, balanced fund Wellington. If you’re not familiar with this one, it’s a fund that contains about 65% stocks and 35% bonds. The long-term annualized return rate is 8.26% which is pretty great in my opinion. You get the added stability of bonds in your portfolio for almost no compromise in returns when you compare this to a 100% stock market index fund.
Hypothetically if someone were to contribute approximately $4,000 each year over the next 10 years into their SEP IRA investing in this fund, their balance would grow to over $70,000! I don’t know about you, but that’s money I’d gladly accept on my path to financial freedom!
Readers – Do you have a SEP IRA or some other type of self-employment retirement savings account? What are some other tricks like this that people should know about to help save themselves thousands of dollars in taxes for the year?
Featured image courtesy of Gerard Van der Leun | Flickr