With this blog post I’m beginning a two-part series about retirement savings plans available to the small business owner. Earlier Jonathan and I have written about the Traditional IRA and the Roth IRA. In this piece I’m going to explain the Simplified Employee Pension, or SEP IRA. It is best used in a small shop, with few (or no) employees. It can be established by an individual proprietor, filing a Schedule C, or by a corporation, LLC, or partnership.
The SEP – Simplified Employee Pension
The SEP is designed for the business owner with few employees. Money goes into the SEP from employer contributions only. All contributions are tax-deductible to the employer. There is no opportunity for employee deferrals. A SEP IRA account is opened for each participant, and all funds contributed are immediately vested. (There is an older version, called a SARSEP, or salary reduction SEP. Although many are still out there, they cannot be opened after 1996.)
The employer must cover those employees who are age 21, have worked for the employer for any three out of the five preceding years, and work more than 600 hours/year. Quick math: 600 hours at 40 hours/week is 15 weeks.
The contribution is as much as 25% of each person’s payroll, up to the maximum contribution allowed by the IRS – $55,000 in 2018. Whatever percentage of payroll the employer contributes to his own account must also be contributed to the employees’ accounts. Say the owner has W-2 income from his own corporation of $100,000, and he pays two part-timers, who each earn $20,000. The employer may contribute $25,000 to his SEP account, and then must contribute $5000 to each employee account.
Can you see how the SEP is best for very small businesses? As a rule, the small employer is going to want to limit benefits paid to employees to the minimum needed to attract qualified employees in the workplace. On the other hand, if all the employees are family members, contributing the same percentage across the board maybe perfectly acceptable, if not desirable.
There is flexibility in the contributions year-to-year. An employer may contribute the maximum one year, or even nothing at all another year. The key point is that the contribution percentage of earnings must be consistent across all covered employee contributions.
Let’s Look at the Taxes
Assume no SEP contribution, and W-2 income of $100,000. $100,000 of W-2 income is reported on 1040 line7. The taxpayer is married filing jointly, so the standard deduction is $24,000. The taxable income is $76,000, and the federal tax due is $6714.
What if that business owner instead made a maximum SEP contribution? Now his W-2 income reported on 1040 line 7 is $75,000. After the $24,000 standard deduction, the taxable income is $51,000. The federal tax liability is now $3834. This is s tax reduction of $2880! Another way to look at it is that it only costs $22,120 to make a $25,000 SEP contribution. That is an immediate return of 13%!
The contribution rules are a little different for the proprietor, who has no separate business entity. This is the owner whose business taxpayer ID and social security number are the same. In this case the maximum contribution works out to be about 18.59% rather than 25%. This has to do with the fact that the SEP contribution is subtracted from the business gross income to arrive at the net income.
The tax savings are even more dramatic here. All contributions are deductible expenses to the employer, before arriving at the taxable income that is reported on the 1040 line 12. No payroll tax (i.e. social security tax) is paid on SEP contributions.
Let’s look at the taxes
$100,000 net business income, which is reported on 1040 line 12. No SEP contribution. The business owner must pay self-employment tax on this amount. The self-employment tax is 15.3% of 92.35% of the business net income. That works out to $14,130 in this case. BUT the business owner can deduct half of this amount on the 1040 line 27. The adjusted gross income (AGI) is now $92,935. After applying the $24,000 standard deduction, the taxable income is $68,935. The federal tax on this amount is $5986. Add the entire self-employment tax of $14,130, and the entire tax due becomes $20,116.
Same facts as above, only our business owner is making a maximum SEP contribution of $18,590. Now he has two above-the-line deductions: half of the self- employment tax on line 27, and the SEP contribution on line 28. The SEP contribution reduces the business net profit, so the self-employment tax is computed on $81,410. The total amount of SE tax is $11,503, of which half, or $5751, is deductible on line 27.
The AGI is now $75,659. After subtracting out the standard deduction of $24,000, taxable income is $51,659. The tax due is $3913. The total SE tax due is $11,503, making the total check to the IRS $15,416. This is a reduction in total tax of $4700 from the previous scenario. Consequently, the $18,590 SEP contribution only cost the business owner $13,890 after tax savings. This is significant!
Why does it appear that the proprietor is paying so much more in federal tax than the W-2 employee? It has to do with the self-employment tax. There are two sides to that tax: the employer and the employee. The W-2 employee has his SE tax withheld and netted out from his paycheck. So although in the first example we had a corporate business owner earning $100,000, his paychecks were reduced by the employee portion, which is 7.65%, or $7650. His employer – himself – paid the other half. In the case of the proprietor, you can see in the example that he does indeed pay both halves of that tax, but gets to deduct half above the line.
An employer may very well be able to contribute the maximum to his SEP, and also contribute to a Traditional or Roth IRA – the limits are separate, but the Traditional IRA may or may not be a tax deduction.
Often business owners split their income between W-2 and 1099 in order to save on self-employment taxes. In the above examples, the corporate business owner may want to pay himself $50,000 in W-2 income, and the other $50,000 as a dividend distribution. There are several pros and cons here:
- the dividends are taxed at a 15% flat rate, which may be higher or lower than the owner’s marginal rate. In 2018, a 12% marginal rate for married taxpayers extends up to $77,400. The next marginal bracket is 22%.
- Self-employment tax isn’t paid on dividend distributions. This has the effect of reducing the immediate tax burden, but can also reduce social security benefits in later years
- A lower W-2 income for the corporate business owner means a lower potential SEP contribution, since the contribution is based on a maximum 25% of payroll – not dividend distributions.
The next post in this series will be about the SIMPLE IRA – the Savings Incentive Match Plan for Employees. Keep on the lookout!
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