A SEP for the Side Gig?

by Prof. Robert Bloink and Prof. William H. Byrnes

The ever-evolving job market has created a new landscape where an increasing number of clients are earning income through some type of “side hustle”—in many cases, as sole proprietors or even small business owners. This, in turn, has created opportunities in retirement income planning that aren’t usually available to clients in traditional employment roles alone. For these clients, who are treated as both employer and employee for contribution purposes, opening a simplified employee pension (SEP) IRA can provide a powerful, tax-advantaged way to supercharge retirement savings or catch up later in life, once the client’s business has taken off.

SEP IRAs: The Basic Rules

SEP-IRAs are retirement planning vehicles that only allow the employer to make contributions on behalf of employees. In cases where the client operates a side business, the client is usually both employer and employee, so can use the SEP as an additional retirement savings vehicle. Like other traditional retirement accounts, SEP-IRAs are funded on a pre-tax basis (i.e., they are deductible by the client).

For 2019, the client can contribute up to $56,000, or 25 percent of compensation up to $280,000. Importantly, the client remains entitled to participate in any retirement plan sponsored by his or her full-time employer and can also fund a traditional or Roth IRA if he or she chooses—meaning that in some cases, the client can significantly reduce his or her taxable income from both the side gig and the traditional job.

One key advantage to the SEP-IRA structure is that a SEP-IRA can be established and funded as late as the tax filing deadline for the prior tax year—i.e., 2019 contributions can be made up until the business’ tax filing deadline in 2020. This timing consideration can add value for the small business owner because the amount of contributions that can be made may depend upon the amount of compensation that the small business owner earns as compensation from the business for the year.

In 2019, small business owners can contribute up to 25 percent of their compensation to a SEP-IRA—up to a firm cap of $56,000 (in some cases, the 25 percent limit may be reduced to 20 percent if the business operates as a sole proprietorship). Because the client often does not know how much compensation he or she has earned from the business until after the end of the calendar year, the ability to make contributions after December 31 can help the client avoid overfunding.

For clients with cyclical side businesses, the SEP-IRA option may be attractive because there is no requirement that the client contribute to the account every year.

As the name suggests,SEP-IRAs are also relatively simple to establish. The IRS has created prototype documents that can be used to form aSEP-IRA, although individually designed plans are permitted. A primary advantage to these plans is that there is no filing requirement for the client beyond using the Form 5305-SEPto create the plan.

Sizing Up the Options

Of course, the SEP-IRA structure is not the only available retirement savings option that clients with a side business can take advantage. Clients who do not already participate in an employer-sponsored 401(k) may wish to consider the solo 401(k) option.

Solo 401(k)s provide a $6,000 per year catch-up option for clients aged 50 and older that is not available using a SEP, and also allow the client to take plan loans. Although the client can withdraw funds from the SEP at any time, they will be subject to tax and a 10 percent early withdrawal penalty if the client is under age 59 ½ (SEP-IRAs cannot provide for plan loans, but exceptions to the early withdrawal penalty do exist).

Further, SEP-IRAs do not provide for a Roth contribution option while 401(k)s can be structured to include a Roth account (although the client remains free to establish a separate Roth IRA if he or she is otherwise eligible). If the client eventually hires employees, some type of 401(k) option may be more attractive because if the client contributes to his or her own SEP account in any given year, he or she must also contribute to the accounts of all employees for that year.

Conclusion

The SEP-IRA option can be particularly valuable for clients looking to supersize their retirement savings based upon extra income earned through a side business in any given year—and in many cases, contributing to both an employer-sponsored 401(k) and an individually established SEP-IRA can help clients reduce taxable income while maximizing their retirement savings potential.