A SEP IRA is How You Put More Money Away in a 401(k) Plan than What You Are Allowed

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Today I want to discuss yet another benefit of owning your own side business, which is your ability to establish a (Simplified Employer Pension) SEP IRA plan. What is a SEP IRA plan?

In plain English, it is a retirement account similar to a traditional IRA or 401(k) plan where your investments / deposits are tax deductible, and your earnings are not taxed until you withdraw them at the age of 59 and a half.

I am writing about this today because last weekend I realized just how much unawareness there is to the advantages of running a side business in parallel to a successful corporate career. My wife and I were invited to a family friend’s place for dinner and conversations were going on about the next best ideas and entrepreneurship.

Somehow the topic of investing came up. Someone mentioned that one of the benefits as an employee is that he gets to participate in a 401(k) plan, to which I responded that a business owner can establish and participate in a SEP IRA plan as well and do much better. Silence dawned upon the room and folks had the deer facing a headlight look.

Anyway, not only are many not aware of the SEP IRA, but also the tremendous advantages that come with it in my opinion, especially for someone earning north of $80,000 annually. I will discuss why this is the case in a bit. Let me first discuss the SEP IRA in a bit more detail.

SEP IRA plans are for small businesses and self employed individuals. It is a simple, easy to establish and administer plan that allows you to stash away up to 20% of your income each year (in 2010 this is a max of $49,900).

That is correct. The best part? You can set up a SEP IRA for a side business even if you already have a 401(k) plan at your day job. Can you imagine maximizing both?

You read correct. As opposed to a 401(k) and an IRA, which limit your annual contributions to amounts much lower than $49,900, the SEP allows you to really leverage the law to your advantage. To put things in perspective, an IRA allows you to contribute a maximum of $5,000 in 2010. A 401(k) lingers in the $15,000 to $16,000 range. Drastic difference isn’t it?

I will not get into the details of what a 401(k), IRA and Roth IRA plans are. I trust you already either know about these or can easily find out. My intent is to highlight an addition to the mix that is extremely beneficial and that not many are aware of.

All these plans allow you to accumulate cash / earnings on a tax free basis. All come with restrictions of all sorts, but nothing that everyone else is not able to cope with. There are some simple guidelines to be followed for each however. There are other kinds of retirement plans for small businesses as well such as the Keogh and SIMPLE plan, but I will not go there right now to keep things simple and my point across.

Which is better, 401(k) or SEP IRA?

Depends what your situation is. Are you making over $80,000 or under?

Let’s assume you are a young buck in your mid 30’s and netted $60,000 in income. Based on the SEP rules, you can only stash away $15,000. If you had earned this income on the other hand and put money away in a 401(k), you’d be allowed to put away $16,500. Someone older and eligible for the 401(k) catch up contribution could put away $22,000.

Now let’s assume you are still a young buck and netted $90,000 in income. Based on the rules you could stash away $18,000 compared to the $16,500 in a 401(k) plan. The more money you make, the more the discrepancy grows between the SEP and 401(k) allowed contributions.

The decision tree appears quite simple and you should know what is best for you at this point. There are many other angles this example can play out as, taking into consideration all complications and variables such as catch up contributions, early withdrawals, if-then and what-if scenarios, etc. But the basic premise remains.

See where I am going with this? As an advocate of side gigging, I love the SEP IRA. It is independent from the IRA and 401(k) plan, which means that I really get to load up on saving for retirement from tax free profits generated by my side businesses. You can too!

Now for this to work, your side business has to be profitable, which is not a difficult task for the average reader of this blog. We are all successful professionals who got into side gigging because we wanted more out of life in the first place.

So assuming your business is profitable (or will soon be), you can take advantage of the SEP IRA investment plan. The plan allows you to report less income when you file your taxes while saving for your golden years at the same time.

So did I address the headline of the post? Sure I did. Although not directly in a 401(k), I hope I have been able to clearly convey how to stash more tax free income away for retirement than what uncle Sam typically allows. This post is just one example why you should pursue a side business.

Readers: So is running your own side gig beneficial in your opinion? Are you or anyone you know involved in taking advantage of the SEP IRA investment vehicle?

Read more about SEP IRA Contribution limits here.

Sunil
Leveraging the System