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  • Writer's pictureRobert Ryerson

Self-Employed Retirement Planning: 4 Things You Need to Know about SEP Plans

Planning for retirement is a complex process that requires consideration of a variety of factors, including annual income, healthcare, insurance, and post-retirement lifestyle preferences. Inflation, which averaged a rate of 3.22 percent from 1913 to 2013, is another important consideration as day-to-day expenses will continue to rise into the future.

Many finance experts suggest that, in order to be properly prepared for retirement, the average worker needs to have a nest egg of at least $2 million, or enough to survive until death on 80 to 90 percent of their pre-retirement income. This might sound daunting for workers who have yet to set aside much money for retirement, but can be even more scary for those who are self-employed.

According to the Pew Research Center, approximately 16 million of the 150 million workers in the United States identify as self-employed. Naturally, these workers can't take advantage of employer-sponsored investment retirement accounts (401ks or 403Bs), many of which offer matching contribution benefits. They can, however, create and contribute to a Simplified Employee Pension (SEP) plan, which functions similarly to a traditional IRA and allows money to grow tax-deferred until withdrawal, but which has much larger annual contribution limits.

How to Start an SEP

Creating a SEP-IRA is a three-step process that begins with a written agreement. Prospective account holders must first either sign: IRS model SEP via Form 5305-SEP, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement; IRS-approved prototype SEP offered either through a bank, insurance company, or any qualified financial institution; or an SEP plan document they created themselves.

Self-employed workers who either work freelance or manage their own business in which they are the sole employee don't need to worry about the other two steps as they relate to setting up accounts for employees. Moreover, these individuals can also simultaneously participate in employer-sponsored plans if their business is a side hustle or secondary source of income.

Small business owners who employ at least one other worker, however, need to provide all necessary information about the SEP-IRA to eligible employees. They must also present a copy of the Form 5305-SEP, a two-page document that outlines eligibility requirements as well as account rules and regulations, to employees. From there, business owners need to create a separate SEP-IRA for each participating employee at a qualified financial institution.

Contribution Amount

Self-employed workers, unlike business owners, need to calculate their SEP-IRA contributions and deductions via a complex computation detailed on the IRS website. This is determined by multiplying their net profit (which is calculated by deducting half of their Self Employment tax from their Schedule C net profit) by the reduced plan contribution rate of 9.0909 percent. Contributions can only be made in cash.

Determining SEP-IRA contribution limits for employees is much easier. Employees can contribute the lesser of the following two figures: 25 percent of their total compensation or $61,000 for 2022, up from $58,000 in 2021. The compensation limit for qualified SEP-IRA plans as of 2022 was $305,000.

The 3-of-5 Rule

Qualifying employees must be at least 21 years old, have worked at the business for at least three of the past five years, and earned at least $650 from the business in 2021 and 2022 to be included in a SEP-IRA. Those who have met these requirements must be included in the SEP-IRA. However, employers can also choose to have less restrictive eligibility requirements and even include those who just began working with the company.

Business owners who adopt the 3-of-5 rule, however, must strictly adhere to eligibility guidelines. Workers must be included even if they worked as little as a few hours in three of the five qualifying calendar years. Employers can correct employee eligibility mistakes via self-correction, voluntary correction, or audit closing agreement programs.

Attractive to Small Business Owners

Many small business owners choose to offer SEP-IRAs as opposed to most other common types of employer-sponsored retirement plans because of the more restrictive 3-of-5 eligibility requirements. This cuts down on costs to the employer. Moreover, SEP-IRAs do not have high operating and start-up costs like other retirement plan accounts, and employers can opt to skip contributions during years in which the business hasn't been profitable. The high annual contribution limits are also very attractive for self employed people who are earning high incomes.

Employers also don't need to worry about managing or making investment decisions with SEP-IRAs. Instead, they can appoint a trustee or financial advisor to select eligible investments, following which the employees can make specific investment decisions. The trustee is also responsible for submitting all necessary documentation to the IRS as well as depositing contributions and sending annual statements to employees. Other employer benefits include adjustable contributions and potential tax benefits.

"The small business owner can create a SEP for themselves and the contributions will typically reduce taxable income, though tax will then be paid in retirement," notes Forbes senior contributor Simon Moore. "Compared to other plans a SEP IRA is a relatively simple solution for saving for retirement."

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