Do you pay taxes on the money you earn from your side hustle? If so, then he’s a hack you’ll want to know: Contributing to a SEP IRA can help lower your taxes as well as allow you to stash away more money for retirement!
For years I’ve enjoyed making money on the side from blogging. But in the eyes of the government, that money is “business income”, and therefore taxable. So while it was fun to earn several thousand dollars per year, it wasn’t so great having to pay roughly a quarter of that money back into taxes every year.
Just like all the steps I’ve taken to reduce my personal taxes down as much as possible, I knew there had to be a way to do the same with my business income.
That’s when I discovered the SEP IRA. By maxing out your SEP IRA contribution each year, you can offset your taxable business income and save roughly one-fourth of what you would normally owe in taxes.
At its peak, that’s been a reduction much as $1,000 in the amount of taxes I owed for the year. But over time, these savings can really start to add up! Perhaps into the tens of thousands of dollars!
If that wasn’t great enough, the benefits don’t stop there! If you’re also in the unique situation where you’re already maxing out your 401(k) and IRA, then a SEP IRA can also be your tool to save even more money for retirement tax-deferred.
Yes, I get to contribute to all three accounts! By doing so, I get to maximize my efforts towards reaching financial freedom and put the power of compounding returns to work making money for me!
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 know how contributing to a SEP IRA could benefit your retirement savings as well as lower your taxable income. Read on to see what a SEP IRA is exactly, how it’s different from the other types of IRA’s, and how it could be used to potentially save yourself 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 $6,000 for the year in ANY combination of the IRA’s you choose.
Example: If you wanted to put $4,000 in a Roth IRA and $2,000 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.)
- $57,000 for the 2020 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 8.33% 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?
Photo credits: Unsplash, Pexels
Jayson @ Monster Piggy Bank says
By just reading the title, I got excited how you did it MMD. I have SEP IRA, but I am not yet maximizing its potentiality. I know it is a wonderful tool for the self-employed .Its low cost and simplicity make it perfect for even a very small business. I actually can contribute over the year or I can make a lump sum payment at any time. Here is what I like the most. The tax advantages are also great – I can get to deduct any contributions from this year’s income and save tax-free.
I just love how it is two-fold: I get to save more money (beyond my 401k and IRA) and I get to save on taxes. This was truly one of those things that when I found out about it, I had to double/triple/quadruple check into it because it just seemed too good to be true. But thankfully its not!
How To Save Money says
Wow! Great way to save some money.
$1,000 bucks saved is a $1,000 earned!
[email protected] says
I maxed out my Vanguard Sep IRA for 2013 and 2014. That is my main retirement account in addition to my Vanguard Roth IRA. I like it- low fees, easy to use online platform, etc. What’s not to like?
You and Greg will probably be able to keep contributing to it long before you ever reach that employer-cap limit. Just think if you did … that would be a ton of taxes that you’d never have to pay.
[email protected] says
I have a solo 401K that acts in much the same way. Since I don’t have any other employer sponsored plan, it works great. I would also encourage people to max out a HSA if they have that option. A health savings account is the only way I know to potentially never pay taxes on income if you use it for medical expenses.
I’m curious – I read with the Solo 401k you had certain “administrative expenses” that you had to pay for and maintain. Do you have those, and if so, approximately how much do they cut into your profits? I’m just guessing but its probably comparable to what normal 401k fees would be.
Good point on the HSA. Take EVERY tax savings opportunity you can get!
John @ Frugal Rules says
Very nice MMD! We both have SEP accounts and maxed them out for 2014, well we’re waiting to hear back from our tax person to see if we can put anymore in it or not and plan on doing the same this year. I just love the ability to be able to put so much away, plus what we can do with a Roth and save money on taxes. It’s an absolute no-brainer in my opinion. The one thing I really want to look into though, and need to really, is the potential for a Solo 401(k) like Kim has above. I know some brokers do charge some sort of admin fee – but it varies as to how much. I’m planning on speaking with our tax person to see how much more we could’ve put away for 2014 and if it makes sense to switch it up we’ll definitely be looking into it.
I do agree John – if you’ve got the money to put away, the whole thing is a complete no-brainer. Save on taxes. Grow your money tax free for retirement. There’s very little not to like about this arrangement.
From the little bit of research I did, I chose the SEP IRA over the Solo 401k because I didn’t want to have to deal with administrative fees and such. You’ve definitely got the right idea to talk to a tax professional and get the real scoop. Plus they might have some more ideas about you can rock these savings accounts even further to the next level!
Shanna Ricker says
There is a great calculator for figuring how much you can contribute at https://www.calcxml.com/calculators/qua12?skn=#results. Enjoy!
Very cool! I like that little calculator.
Jon @ Money Smart Guides says
I set up a solo 401k in 2013 and used it last year to funnel a lot of my online income into. We have our appointment with our accountant this weekend and I will know for certain how much more I can put in for 2014. I did the math, but I like knowing that the CPA agrees with me. I don’t need the IRS knocking on my door!
That is absolutely the same reason I use an accountant as well. Of course most of us could fill out a Form C, crunch the numbers, and come up with some figure. But who really knows if we did it right? I agree – it’s worth it to have that peace of mind of leaving it to a trusted professional.
EL @ Moneywatch101 says
Great explanation on how to contribute to a SEP IRA. I have heard of this account before, and all the great benefits behind having one. One thing that I never see is at what side business income level, is the point where you have to begin setting up a business entity? I seem to not find the info easily,
Abigail @ipickuppennies says
Wow, I didn’t realize there were no admin costs. I’m looking at setting up a SEP either later this year or early 2016.
I still prefer Roth IRAs, so I’ll fund that first. If possible, I plan on working at least part-time even in my retirement years, and I keep getting raises. For that reason, I really wish there were a Roth SEP, although I know that kills some of the tax incentives.
At any rate, I was thinking about going to Vanguard anyway, so this definitely cements it for me.
Hello and welcome to the site! Whether you go with the Roth or SEP, you’ve definitely got the right idea to save your money!
On the Roth vs Traditional style plans, you might find this interesting.
Always great to save money on taxes. Nothing is more infuriating than having to give your hard earned money to the IRS. It makes me think of the episode of “The Honeymooners” where Ralph says “I’d rather the government keep my paycheck and I’ll keep the income tax!”.
My question, though, is how one incorporates IRA’s and other tax-sheltered accounts into a strategy of early retirement? I’ve seen your plan and it is a great one, but it is designed around your income which appears to be sufficient enough to max out a 401k, multiple IRA’s, and a dividend stock portfolio (and hey, if that is true, then that is awesome!). What about if you are a low-moderate income earner? I see the earnings power of IRA’s and the like, but if you can’t touch them until you are 59 1/2, then how do you use these to achieve early retirement? I say this as someone who is relatively frugal but does not earn a particularly high income (I’ll use those as my choice words; I’m not going to divulge my salary on the Internet) and can’t really contribute any significant amount to–let alone max out–a Roth IRA AND a 401k AND a dividend stock portfolio AND a SEP IRA if my blog ever gets moving, so on and so forth.
That’s an awesome quote! I’ve never heard it before. But now I think I’ll have to start using it.
Your question is exactly the same one I had about two years ago – so from one early retirement enthusiast to another I’m very excited to answer it!! One word: A “72t”. Read my impromptu interview with Vanguard here. Basically there is a little known tax loop hole that allows you to withdraw your money early under the condition that you agree to take out a small annual withdrawal called a SEPP. As long as you follow the rules correctly (with the help of an accountant) you can use this little trick at any income level; you don’t have to necessarily be maxing out your accounts. This is totally how I plan to access and enjoy my life savings way earlier than age 59-1/2! The trick of course is then to make sure you’ve got enough capital saved up to cover you for a lot more than the traditional 30 years everyone seems to use since you’re dipping into your nest egg ahead early.
Taylor Lee @ Engineer Cents says
My employer auto-contributes to our SEP IRA so I think they are the best! If I had enough side income I’d set one up for my own business as well.
That’s great to hear your employer contributes. I wonder how that would work out if you did have significant income of your own from blogging (which you will someday soon if you keep up with it) … Sounds like a question for a tax professional.
Benjamin Davis @ From cents to retirement says
Will you continue to max it out in the next months? Great way to save on taxes and build up for your retirement. Keep up!
Because we max out our Roth IRA’s, the ~$3,000 is upper limit of what I can contribute into the SEP IRA as my own employer. As a whole, our goal is to max out all our contributions on all fronts: 401k, 403b, both Roth IRA’s, and the SEP IRA.
Had an experience today with TurboTax and putting the SEP IRA monies for my small business into the right category in their software. If I put it into the Less Common Business Situations (under my Schedule C) it raised my taxes because it conflicted with my personal (traditional) IRA mix (not letting me take both). It essentially considered me the Employer not Employee.
But we read about putting the SEP IRA deduction in a different place (here) and it worked out.
B and A W
Thanks for the observation. I’ve never tried to do an SEP IRA on my own; only with a professional.
Thanks for this post.
BTW: Quick tip is that 0.25÷ 1.25 gives you 0.2(20%). That’s why multiplying directly by 20% gives you the same answer. It is not magic. 😊