A couple of decades ago, opening a SEP-IRA retirement account was not common practice or even common knowledge for that matter. After graduation, many people vied for employment at a large corporation and were comfortable ‘staying down’ with the company for 20 years or more to earn pension and retirement benefits.

Today, Freelancers are the fastest growing sector of the economy comprising 35% of the U.S. workforce, cumulatively earning $1 trillion in 2015, according to the survey “Freelancing in America: 2016” released by the Freelancers Union and Upwork.

The study also revealed that most freelancers believe that having a diversified portfolio of clients is more secure than being employed by one company. Confident about the respect and sustainability level of the industry, over 46% of full-time freelancers increased their rates — needless to say freelancing is here to stay. Despite being satisfied within the industry a recent Freshbooks survey reveals that 40% of freelancers and self-employed individuals have not allocated any funds towards their retirement.

"Many times with sole proprietorships, these businesses are neglecting SEP-IRAs,” commented Andrew Watts to CNBC.com. Watts is the of wealth management at HD Vest Financial Services.

With the main attraction of freedom and flexibility, more and more people will continue to transition into freelancing to make ends meet — thus becoming self-employed and accountable for their own retirement savings plan account.

One of the best ways for freelancers and small business owners to manage their retirement savings is via a tax deferred SEP-IRA, an acronym representing a confusing display of letters that stands for simplified employment pension individual retirement account. A SEP-IRA is an economical alternative to the more expensive and less flexible; traditional 401k, Roth 401k, Roth IRA and traditional IRA retirement savings account options.

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Self-employed must learn to save for retirement

Without the crutch or promise of a pension plan, many freelancers and self-employed business owners retirement success depends vastly on their ability to save their own money. One of the best techniques to do this in a tax advantaged way is via an SEP-IRA, a special tax deferred plan available to a business with one or more employees, freelancers, and self-employed individuals.

Money can be placed into SEP-IRA accounts even if the freelancer or employee participates in a 401k or other retirement plan.

Considering that up to 25 percent of the employee’s contributions (20 percent of the net adjusted income for unincorporated businesses) or a maximum of $54,000 for 2017 can be allocated to the SEP-IRA account, more freelancers and self-employed individuals should take note. The contribution amount for a SEP-IRA account has a significant advantage over the $5,500 ($6,500 for individuals 50 and older) annual limit imposed on traditional 401k and Roth IRA account.

Highlights of SEP-IRAs

When taking into an account if an SEP-IRA will work best for them, freelancers and small business owners should consider the following facts about the plan:

  • There are no steep or significant administration costs
  • Only the employer can contribute funds to the SEP-IRA account
  • Employee possesses 100% ownership of all SEP-IRA money
  • An eligible employee is 21 years of age, has worked for the employer in at least 3 of the last 5 years and has been compensated at least $600 in the current year.
  • Contribution limits are significantly higher than personal IRA accounts ($54,000 or 25% of salary in 2017 and additional $6,000 catch up contribution for participants age 50 and older)
  • Flexible annual contributions making this retirement account plan good if cash flow issues arise.
  • Annual contribution percentage is flexible on a year-to-year basis
  • Employer must contribute equally for all eligible employees
  • Contributions to SEP-IRA accounts are usually 100% tax deductible
  • Money growth is tax deferred
  • Can still contribute to a traditional or Roth IRA account
  • Withdrawals made before age 59 ½ are taxed as regular income and subject to an additional 10% early withdrawal penalty
  • By age 70 ½ participants must begin receiving required minimum distributions

Who needs a SEP-IRA?

An SEP-IRA retirement account makes sense for the following people:

  • Self-employed individuals without any employees, earning high wages. As previously stated, an employer must contribute the same percentage to all qualifying or covered employee SEP-IRA accounts, if there are a lot of employees this type of retirement account could get very expensive.
  • Salaried or gainfully employed individuals with a side hustle. Even if they are participating in an employee sponsored 401k or IRA account, the SEP-IRA will not be affected by the plan at the company they work for. In an ideal situation, the individual could live off of the money earned from their employer and place all or a large portion of their earnings from their side hustle into a tax-deferred SEP-IRA account.

Opening a SEP-IRA account

Opening a SEP-IRA retirement plan account is a very straightforward and uncomplicated process.

The first step is to select a financial institution to serve as a trustee and to begin the enrollment process.

Maura Cassidy, the vice president of Fidelity Investments, confirms the popularity and simplicity of opening a SEP-IRA retirement account for small business owners and self-employed individuals.

“The nice thing about the SEP-IRA is that it is very easy to set up because an IRA doesn’t have as much paperwork,” Cassidy stated in Employee Benefits News.

If there are employees you must complete the following essential steps:

  1. Create a written agreement outlining intent to provide benefits to all qualifying employees.
  2. Provide employees with detailed information regarding the SEP-IRA, including provisions for participation and how the contribution is calculated.
  3. Establish SEP- IRA accounts for each employee via the financial institution selected as the trustee.

SEP-IRA self employed business owner example

Let’s investigate how a SEP-IRA account can be a great tax advantage to a consultant, freelancer or other self employed candidate.

In the first example Freelancing Tyrone made $130,000 in 2017 and will not be receiving income from an employer. Since Freelancing Tyrone is not receiving a W-2, his contribution is contingent on a reduced rate limit of 20% of his net adjusted self-employment income:

Freelancing Tyrone

  • Net profit (or total self employment income): = $130,000
  • Net self employment income*: ($130,000 x 92.35%) = $120,055
  • ½ self-employment tax deduction**: ($120,055 x 15.3%) = 18,368 / 2 = $9,184
  • Net adjusted self-employment income: ($120,055 - $9,184) = $110,871
  • Reduced plan contribution rate: = 20%
  • Allowable SEP-IRA contribution and deduction: (110,871 x 20%) = $22,174

In the next example will show the results of a Ballin’ Annie, a slightly higher earning self employed consultant and keynote speaker, bringing in $300,000 in 2017.

Ballin’ Annie is single with no employees:

Ballin’ Annie

  • Net profit (or total self employment income): = $300,000
  • Net self employment income*: ($300,000 x 92.35%) = $277,050
  • ½ self-employment tax deduction:

Social Security** ($127,200 x 12.4%) = $15,773

Medicare** ($277,050 x 2.9%) = $8,034

Total = $23,807

Add’l Medicare Tax for Higher Salaries: @ 0.9% ***

($300,000 - $200,000) = $100,000

($100,000 x 0.9) = $900

Total = $24,707

Self Employment Tax Deduction ($24,707 / 2) = 12,354

  • Net adjusted self-employment income: ($300,000 - $12,354) = $287,646
  • Reduced plan contribution rate: @ 20% ($287,646 x 20%) = $57,529
  • Allowable SEP-IRA contribution and deduction: $57,529 is over the maximum amount allowed of $54,000 so in this example Ballin’ Annie’s maximum contribution is $54,000 to her SEP-IRA account.

Both Freelance Tyrone and Ballin’ Annie are able to save a significant amount of money in their SEP-IRA accounts.

They both would also be permitted to contribute up to $5,500 in their Roth or traditional IRA account, giving Freelance Tyrone a generous retirement savings total of $27,674 for the year. Ballin’ Annie could roll over the $3,529 overage from the example into her Roth or Traditional IRA account as well allowing her to save the entire 20 percent of her earnings at $57,529, or she could max out at $5,500 for a total of $59,500 for the year between both savings accounts.

The verdict

For individuals that are self-employed with no (or very few) employees and bringing home some serious cash or those that have a legit side hustle; it would be wise to consider building (or advancing) their nest egg with a SEP-IRA account.

The flexibility and tax advantages that come with having one are worth investigating and research. The key is to get started as soon as possible in order to relax and breathe easy when you reach the retirement zone.

Cassidy notes that freelancers and self-employed individuals should assess their retirement plans and explore all available opportunities.

“If they are doing something with a side business or are full-time self-employed, they should look into [SEP IRA] accounts for themselves. I’m a firm believer in retirement savings,” she concludes.

*Net self-employment income is the amount of your self-employment income used to calculate self-employment tax. When you are self-employed, you do not have to pay FICA or self-employment tax on all your salary, just on 92.35% of it (92.35 being 100 minus 7.65 - which is the contribution that the employer would have paid, but there is no employer).

** The self-employment tax deduction is equivalent to half of the 2017 Social Security (12.4%) and Medicare (2.9%) tax equivalent to 15.3% on the first $127,200 of net self-employment income.

***Since 2013 high-income earners are required to pay an additional Medicare tax at a rate of 0.9% for any income above $200,000 for single filers, $250,000 for married filing jointly or $125,000 for married couples filing separately.

Calculations were done with Moneychimp.com’s Social Security and Medicare Contributions calculator

This is not intended as personal financial or legal advice. Please consult your legal and tax advisors before making any changes to retirement plans. Not all provisions will apply to everyone's situation.