A few weeks ago when I laid out my ultimate plan for becoming financially independent, I thought I had really done a pretty good job of optimizing every single angle of my retirement savings options.
My 401k. My IRA. Is there anything else I’m possibly missing where I could find even MORE tax-deferred savings?
Apparently there is!
And as it turns out it has a lot to do with this blog. So all of my blogging friends or people earning any kind of side income may want to listen up …
Another Helpful Phone Call with Vanguard:
Over the Christmas holiday, I offered to help my sister explore her options for retirement savings. Since she is a freelancer and basically self-employed, I knew the rules would be slightly more involved than the more conventional options that I am used to.
With nothing more than a few ideas in mind, I decided to call the people who would probably know best – Vanguard – and see what I could learn from them.
After only a few short minutes, I was chatting with one of their retirement specialists and our conversation seemed to focus on the subject of a SEP IRA (Self Employed Pension IRA). (There will be a lot more info below on just what the SEP IRA rules actually are.)
From a self-employed perspective, this one really seemed to stand out among the other options.
But then the agent said something to me that I wasn’t expecting. Something that was a game-changer.
“You know that you could contribute to one too ….”
One More Way to Grow My Money Tax-Free!
“I” could contribute to one to?
You see when we were talking about the actual mechanics of how this SEP IRA would work, I had mentioned that I too make a side income from my blogging efforts.
That’s when the Vanguard agent mentioned that you can contribute to a SEP IRA even if you participate in another retirement plan such as with another employer 401k. I later independently verified this statement to be true.
So what does that mean?
It means that if you’re a full-time employee for some job (like myself) BUT you also receive some sort of income on the side, then you COULD contribute to a SEP IRA in addition to all your other retirement strategies!
That may not sound like a big deal. But consider that the contribution limits can go as high as $52,000 in 2014! That’s a lot of money you could potentially be stashing tax-free!
How Does This Benefit You?
Do you really like paying a bunch of taxes on your blogging income or passive income streams? I sure don’t. And I’d love to use any legal means out there I can to make that number as low as possible!
That’s what I like about this prospect!
Not only could I be lowering my overall tax bill, but it would mean that I would get to save more of my earned money.
Follow my logic. If you’re like me, you probably:
- Do something that earns you a side income (for me, it’s this blog)
- You pay taxes
- Save or invest whatever is leftover
Recall in my post about Tax Deferred vs Taxable Retirement Income Strategies, we learned that the tax deferred savings route didn’t just beat the taxable one, it beat it by A LOT! In one of the examples, we made over $1.9 million dollars more in accumulated wealth! That’s no small chunk of change to disregard.
So that’s what I like about the prospect of using a SEP IRA. My process would then become:
- Do something that earns you a side income
- Save or invest a portion of your earnings
- Pay taxes on whatever is leftover
That’s going to be a much better deal for me!
The SEP IRA Rules and Fundamentals:
The Basics:
To summarize, a SEP IRA looks and acts just like a regular traditional IRA.
- (With Vanguard) There are no annual fees or establishment fees
- You can invest in whatever you would normally invest in with your IRA today – mutual funds, stocks, etc.
- Taxes are paid later in life when you retire rather than now
- You can’t touch it until age 59-1/2. Otherwise you have to pay that 10% early penalty.
- There are required minimum distributions when you reach age 70-1/2
Contributions:
As it was explained to me, it helps to think of your SEP IRA in two parts:
- The employer.
- The employee.
If you are self-employed, then you are actually both and entitled to save on both sides of the fence.
As an employee, you get to save $5,500 per year in this SEP IRA. HOWEVER, keep in mind that this does affect your ability to contribute to other types of IRA’s. You can’t exceed $5,500 in any combination of IRA’s whether they be a Traditional, Roth, SEP, or anything else. So if you’re already contributing to a Roth, then this part of the equation isn’t available to you.
Now on the employer side is where you reap the benefits! As the employer of this self-owned business, you also get to make a total contribution that doesn’t exceed $52,000 (for 2014) or 25% of your income; whichever is less.
The definition of “25% income” is the tricky part, and the Vanguard agent advised that I seek the help of an accountant to assist with that. Apparently the way that works is its 25% of your gross compensation. So what exactly counts as “gross compensation”? Is it Revenue – Expenses? This is where you or I would have to speak to a true tax professional to figure it out.
So How Much Extra Money Would I Make?
To really illustrate how much extra money this strategy may or may not make me, let’s run through a simple real world example and see what the benefits would be.
So let’s say last year I added up all the revenue and expenses from my side income (my blogs) and decided (with the help of an accountant) that my gross compensation was $10,000.
My employer contribution to my SEP IRA would then be 25% x $10,000 = $2,500
That would leave me with $10,000 – $2,500 = $7,500 of taxable income.
If I’m the 25% tax bracket, that would be $1,750.
What if I hadn’t contributed to that SEP IRA?
Then my taxes would be 25% x $10,000 = $2,500
That means I got to keep an extra $2,500 – $1,750 = $750 by using the SEP IRA.
While that might not sound like a ton of money, consider that over a 10 year time frame with 8% inflation adjusted returns that $750 per year could grow into $9433!
No matter which way you look at it, I think we could argue that it would be worth it to at least speak to a professional accountant and see how I could go about taking advantage of this.
Readers – Does anyone already have or participate in a SEP IRA? Were you aware that the SEP IRA rules allow you to invest a lot more than you may have previously understood it to?
Related Posts:
1) Using a 72t Distribution to Get Early Access to My Retirement Savings
2) Could Early Retirement Planning Be Ruining Me?
3) Your Plan for How to Become Financially Independent
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Great breakdown of the SEP MMD! As you know, my wife and I opened ours at the end of last year and have started funding it already. I love the possibility to fund to the extent that it allows and thankful we have a tax guy who can tell us how much each of us can put in. 🙂
Thanks John. I do remember reading about that on your site. I’m excited about the prospect of doubling up on both my 401k and the self-employed side of the SEP IRA. That’s a lot of dough to stash away!
Great post! I have had a SEP for almost 4 years now. It started with my day job and it was nice because my employer always contributed the full 25%. I still have my own now that I’m self-employed too.
Did you work somewhere that didn’t offer a 401k? That’s pretty generous of them to contribute the full 25% to your fund.
SEP IRAs and Self-directed 401ks are a great way to sock extra money away tax -defered if you have self employment income. There are some subtle differences between the two you might want to research on as well. I believe the SEP IRA works out as the easiest option if you are already maxing out a 401k as an employee, but if you are fully self employed then the self-directed 401k allows you to defer up to the 401k limit of 17.5k at 100% of your income (instead of just the 5.5k IRA limit) in addition to the 25% employer contribution (with a similar total make of 52k).
in your present situation i think the SEP IRA is the way to go, but not sure how difficult it would be to switch to a Self Directed 401k if you wanted to later on.
Here are a couple links that i have read before on these two:
https://www.sepira.com/sep-ira-vs-individual-401k.html
https://www.getrichslowly.org/blog/2013/06/06/sep-ira-vs-self-employed-401k/
Nice to hear from you again Lucas.
Good input! If I ever was fully self-employed, then the self-directed 401k would be the better choice. Since I’ve still got a long ways to go before I’m retired, I’m going to start taking advantage of the SEP IRA for now.
Nice breakdown. It’s really a great tool. We’ve been meaning to open a Solo 401(k) for my wife just because it’s a little more flexible in terms of how much you can contribute, but I honestly don’t know how that would interact with an existing employer plan (she doesn’t have one). That’s an interesting little wrinkle.
That Solo 401k will be a great way for the two of you to save. Unfortunately that one is not an option for me – maybe someday when I’m my own boss!
Nice look at this MMD. That sounds like an awesome tool to use if you have the side income… lower taxes, and more money saved for retirement in tax-advantaged accounts. That’s a big win-win!
Thanks Jon. I was pretty excited to find out that the SEP IRA is an option for me. Just one more way to hide my money from the tax man!
Nice post. I am always looking for other ways to save for retirement and these little tricks and tips are so interesting. I had no idea this even existed.
It’s very interesting how many little loop holes and tricks there are when you really start digging around. It’s also kind of fun learning about them because it makes the prospect of financial freedom feel very, very real!
I just opened a solo 401k because I no longer am eligible for a company plan. I’m not sure if I’ll get 52K in there, but I’m hoping to put most of my 1099 income in there. Rental income and income from my doing seller finance for the sale of the practice is not taxed as normal income, so we’ll save a ton doing it that way.
Nice work! Even if you don’t reach the full $52K, that will still be really impressive to get a couple grand stashed someplace where you won’t owe taxes for quite some time.
Nice work! Even if you don’t reach the full $52K, that will still be really impressive to get a couple grand stashed someplace where you won’t owe taxes for quite some time.
Cha Ching! That’s awesome. I’ll bet you were giggling as that phone call ended.
I’ve been self employed forever, so a SEP has been the heart of my personal plan (along with Cheryl’s 401k from her employer). I like the fact that I can also call the shots inside of the plan. Because Cheryl’s plan has limited investments, the SEP gives me the ability to round out our diversification.
How did you know? I was laughing like a mad-scientist after that phone call! Now all that does is raise my curiosity even more to find out what other tax sheltered strategies I’ve been missing out on.
Great work!. I’ve been enjoying discovering the various tax strategies that you’ve outlined. The SEPP is completely new to me. I’ll have to see what I can make it work for in my case. I’m still yet to get over how much the 401k max out will add for us!
I’m just as amazed as you every time I find one of these new strategies out. Some day perhaps I’ll unify all of them into one giant strategy that will result in me paying no taxes whatsoever!
I finally did a SEP IRA in 2013 and am thankful. I miss my employer 401k profit contribution. It used to be like $20,000 – $25,000 a year!
I just met with an accountant and will be setting one up from here on forward! I can tell this is going to be a good move – anything to save on taxes!
I can feel your pain for missing out on that 401k contribution. I do pretty good with my own employer contributions and that is one of the big considerations I have for NOT quitting my job or trying to set out on my own.