Benefits of a SEP IRA for business owners
Benefits of a SEP IRA for business owners
What is a SEP IRA? Many of you know what a traditional IRA and a Roth IRA are. Both were developed to give people the means to build their savings for retirement in a tax efficient manner. A SEP IRA (simplified employee pension IRA) allows business owners the means to provide retirement benefits to themselves and their employees. Businesses will include activities that earn taxable income, including proprietorships, restaurants, farms, ecommerce businesses, even a YouTube business.
Benefits of SEP IRA
There are obvious benefits to a SEP IRA. Like a traditional or Roth IRA, once a contribution has been made there is tax deferred growth until retirement. This means you don’t have to pay taxes on capital gains or income received from dividends or interest while gains are being made in the account.
Nonobvious benefits
One of the biggest benefits of a SEP IRA over other IRAs is that you can take deductions on SEP IRA contributions in a way that can shield you from paying as much in tax in a given year. This is because the contribution limit is much higher than a traditional or Roth IRA. And therefore, the deduction you can take is that much higher. The deduction can be used, and business owners have used it, as a tax shield to limit the amount income tax they must pay in a given year.
Example
Suppose as a business owner you are going to earn $200,000 in profit from your business in a particular year. If you did nothing else that profit would be taxed at the 15.3% rate for proprietorships. And so you could pay the tax to the IRS and be done with it. However, you will never see that money again. So you can look for ways to minimize the amount of tax that you need to pay in that particular year.
One option would be to make an expense before the year is out for items that you may or may not need. Let’s say you are a farmer. So you buy $50,000 worth of seed and fertilizer. You may not need them now, but they are the kinds of items that you can store for use some time later. You lowered your taxes because that expense brought your profit down before the end of the year. (The government can’t tax your business for profit it has not earned.)
A second option would be to make a contribution to a SEP IRA of $50,000, which is (1) better than the first option where your capital is dormant, because here you are making contributions toward retirement. And (2) you will still get the benefit of taking a deduction and thereby lower your tax for the year. Like a traditional IRA the amount contributed will be deducted. But unlike a traditional IRA, the contribution limits are much higher (up to $66,000 in 2023.) In this instance, the contribution that can be made is 25% of the income earned, or $50,000. But this deduction can also be used to offset income from other places, whether it is income from other work or income from a stock portfolio.
One important qualification is that a SEP IRA is a pension plan. And if you have eligible employees, you will be required to match contributions in their SEP IRAs equal to 25% of their salary. (This also includes seasonal workers if they earned more than $650 or worked for the business in 3 of the last 5 years and are older than 21. But non-resident aliens may be excluded.) However, there are no operational costs associated with making a SEP IRA contribution, unlike a 401K plan for employees which involves set up fees and ongoing fees to a third-party administrator.
If you are a business owner and are interested in the advantages of SEP IRA, please contact your financial advisor who can walk through the details with you.
