Sole proprietors and other types of small businesses were once at a disadvantage because they were excluded from the benefits of employer-sponsored retirement plans. Now, they can enjoy the benefits of saving for retirement with a Simplified Employee Pension (SEP) plan. This account is in the form of an IRA and has different contribution and tax rules than an employer-sponsored retirement account.
How SEPs Are Different
As a small business owner, you pay yourself a salary from the money that the business earns. You are then eligible for a tax deduction for the amount contributed to a SEP IRA. Some SEPs also have higher contribution limits than employer-sponsored IRAs. Also, with this type of account, employer contributions do not have a waiting period before they are vested.
The SECURE Act
In December of 2019, the Setting Every Community Up for Retirement Enhancement Act (SECURE), allowed a small employer to be eligible for a tax credit to offset the costs of beginning a retirement plan. This tax credit can be used to offset the costs of starting a 401(k) or a SIMPLE IRA. A small employer must follow certain rules for which employees can be included or excluded from the plans.
SEPS and Taxes
For tax purposes, SEPs are treated like traditional IRAs. They have the same investment and rollover rules. As an employer, you receive a tax deduction for the amount of the contribution.
One way that a SEP is different from other IRAs is that the employer is not locked into a certain contribution amount every year. You can change the contribution amount from year to year.
Once deposited, SEP amounts become traditional IRA contributions for tax purposes. One thing to keep in mind if you are a small business and not a sole proprietor is that only employee deductions are tax-deductible but not the employer contributions.
Taking the SEP Tax Deduction
One of the most common questions about SEP contributions and the self-employed is where to take the deduction. Retirement contributions are typically 10 percent of your compensation, but you cannot simply multiply your net profit by 10 percent and record it on your Schedule C deductions. First, you must calculate your self-employment tax using Schedule SE.
Then, you must use the adjustments to your net earnings to calculate the plan compensation. If you are self-employed, you must follow special rules to calculate retirement plan contributions.
Once you have calculated the amount that can be deducted, your contributions are recorded on Form 1040, Schedule 1, not Schedule C. Each year, the form changes, but you will see a line dedicated to self-employed SEP, SIMPLE and qualified plans. If you did not do this correctly in previous tax years, you must file an amended return to make this correction.
If you are self-employed, the rules are different than for a small business. If you are a sole proprietor, IRS Publication 560 has an explanation of how the rules apply to you. It provides both instructions and examples to help you interpret how to contribute and take the tax deduction.
Only some small businesses are eligible to start a SEP. If you want more information about SEPs and how the IRS rules apply to your business, the IRS website has a wealth of information. Small businesses and the self-employed are the lifeblood of the economy, and planning for retirement is just as important for you as for large corporations. Just because you operate or work for a small business does not mean that you cannot have the same retirement dreams as those who chose a different path, but the rules are different and you must make sure that you treat them correctly for tax purposes.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.