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Primer on Self-Employment Taxes, or Why SEP-IRAs?

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Why am I opening a SEP-IRA? The short answer is because I don’t want to pay taxes today if I can delay them into the future, say, in twenty years or so when I’m gray and ready to sail off to the Bahamas. Right now, all the income from this blog and Bargaineering is considered self-employment income. On self-employment income, unlike regular employment income from my job, I have to pay a self employment tax and an income tax – double whammy.

The self-employment tax is based on the income reported on Schedule C: Profit or Loss From Business (link to the Schedule C instruction pdf from the IRS) and is 15.3% of the net income (profit). So you pay that and, since the business income is reported as income on your tax return, the regular income tax you pay. If you made $1,000 in business profit and are in the 25% tax bracket, you pay $153 in SE tax and $250 in income tax, for a total of $403 in taxes on $1,000 of additional income. Ouch.

You can break out the 15.3% self-employment tax: 12.4% to Social Security and 2.9% towards Medicare. The maximum you have to pay towards Social Securiy is $11,160 (2005) so if you happened to make a million bucks, you pay the same social security as someone who made $90,000 in self-employment income. There’s no maximum for Medicare. That ends the self-employment tax primer…

So, now we get to why I want to open a SEP-IRA. A SEP-IRA contribution is deductible as an expense and so for ever $1 I contribute, I pay forty cents less in taxes this year. When I take distributions when I’m retiring, I pay my income tax which will likely be less than 40%.

There is a downside… the site didn’t make a tremendous amount and there are usually fees associated with the brokerage maintaining the SEP-IRA. On my Vanguard account, there is a $10 custodial fee for balances under $5,000. So, if I only can contribute $500 to the SEP-IRA this year, that $10 fee represents a 2% “tax” each year. (Vanguard SEP-IRA account information page) Luckily there are no other fees.

Finally, in my Vanguard SEP-IRA I can only contribute to mutual funds and the “smallest” fund is their STAR Fund ($1,000 min). Since as an employer my contribution limit is $461, I’m going to contribute an additional $600 as an employee as an employer for 2006 for a starting balance of $1,061 from which a $10 fee will be deducted since the balance is under $5,000. I’ll do a brief writeup on the STAR fund in the future but it’s a decent fund with a 11.15% return since it’s inception in 1985.

Update: Thanks to TurboTax and Gail’s questions, but I did a little more digging and learned that the employee contribution to a SEP-IRA was considered a contribution to a Traditional IRA, so the cap of $4,000 extends to Roth IRAs as well. Since I already fully funded my Roth IRA for 2005, I had to recode my deposit from a 2005 Employee contribution to a 2006 Employer contribution.

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20 Responses to “Primer on Self-Employment Taxes, or Why SEP-IRAs?”

  1. Miller says:

    So you pay the income tax (25%) on the total profit and not just the profit after self employment tax? That really does suck!

  2. Gail Macdonald says:

    Funny thing. I actually just opened a Sep IRA with Vanguard today. So, just a refinement to the excellent information you provided. The Small Business Counselor with whom I discussed this transaction advised me that the $1,000 minimum is waived for Sep IRA accounts, so I was allowed to open my Wellington Fund with an employer contribution of only $757. (I couldn’t make an employee contribution because I already maxed out my contributing power by making the maximum contribution to my Roth IRA this year).

  3. jim says:

    I wasn’t aware that the Roth IRA and the SEP-IRA counted towards the same limit.

  4. jim says:

    Gail – The contribution limits on IRAs with respect to Roth IRAs only applies to Traditional. So you’re limited to $4,000 in Traditional and Roth IRA contributions but a separate cap exists for SEP-IRAs.

    “Be aware that you may contribute to a Roth IRA and a SEP, SIMPLE, and/or Education IRA at the same time. The annual contribution limit on IRAs is only applicable to the combination of traditional and Roth IRAs. So if you are in a situation where you are able to fully fund a Roth IRA and a SEP, SIMPLE, and/or Education IRA, the law allows you to do so.”

    http://www.fool.com/money/allaboutiras/allaboutiras04.htm

  5. Laws Finance says:

    I believe that Vanguard will allow you to pay the $10 fee out of pocket. That is, it does not have to come out of the IRA money that you are putting into the account. That way you can get more into the IRA if you are at a cap of some kind. At least that’s the way it worked when I first opened my Roth IRA.

  6. Gail Macdonald says:

    This could mean some more savings for me, so I want to be clear. My understanding of the Sep/Roth issue is as follows: As an employee, I can contribute to either a traditional or a Roth or a Sep-IRA, but any combination of contributions is capped by the $4000 IRA limitation. As an employer (sole proprietor), however, in addition to any employee contribution I may have made to any type of IRA, I can contribute up to 25% of my net income as an employer contribution to a Sep-IRA. Are we saying the same thing? Or are you saying there is a separete “employee” cap for Sep-IRAs as well?

  7. Anon says:

    1) The self-employment tax is the same as the employed tax; although your employer is paying part of your payroll taxes for you, from their accounting perspective (and therefore yours) it is no different than your salary.

    2) Isn’t FICA calculated on gross income, not net? I don’t think you can avoid payroll taxes this way. In other words, you’d be saving 25%, not 40%.

  8. jim says:

    Gail – You’re right, from the employee side it’s considered a traditional IRA and subject to the same limits. I was mistaken.

    Anon – I think you’re right, when I initially set this up I thought I was avoiding the whole thing (FICA = medicare + SS) but I’m not because I deduct half of FICA as an expense, which just means deductions are only saving me 25% (income tax).

  9. Bargaineering,

    What a great discussion. I provided a fairly detaild reply to the similar tax savings discussion on the fivecentnicket site, but would like to provide a bit more information (more clear information here).

    BTW, this link goes to my discussion of self-employment taxes and retirement contribution limits http://makingourway.blogspot.com/2006/03/curious-question-to-ask-about.html.

    Here is a quick summary:

    Contribution limits:
    Like contribution categories share total limits; i.e. Defined contribution plans share the same $44,000 limit for 2006. Defined plans are SEP-IRAs, 401ks, 403bs and individual 401ks. I didn’t research it but based on previous comments it sounds like roth ira’s and tradtional ira’s face the same contribution limits $4,000 each – I hadn’t heard this before.

    Traditional IRAs
    The IRS guidelines (and my account) have often told me that I could contribute to a traditional IRA after maxing out my 401k, however, the contribution would not be tax deductible. I wonder if this is still the case if you contribute to a roth ira?

    Payroll Taxes
    Must be paid on the gross amount and are not effected by retirement contributions. If you’re self-employed you pay the double wammy, but you have a partial benefit – you can deduct half of the self-employment tax. Since it’s a deduction, rather than a credit, you’re not getting the whole amount back.

    SEP IRAs
    The most recent IRS guidelines no longer distinguish between employer and employee contributions to a SEP, which makes a lot of sense, since the self-employed can arbitrarily recategorize them. There is still the overall limit of $44,000 (this year) or 25% of your salary.

    Retirement Account Fees
    First Trade (www.firsttrade.com) doesn’t charge any retirement account fees for low balance accounts. They also charge only $6.95 for equity trades.

    A Different Strategy
    I strongly recommend that you reconsider contributing your savings to a SEP IRA. Instead, you might want to consider contributing to an Individual 401k, as it allows you to contribute the first $15,000 of income earned to the 401k, without being limited by the 25% that a SEP IRA places upon you.

    Good luck.

    Making Our Way
    makingourway.blogspot.com

  10. 2million says:

    I have to agree with MakeOurWay’s comment – why did you opt for the SEP IRA? I have been looking at my options and was leaning to the Individual 401(k) – Fidelity seemed to offer a great plan that had no annual fees.

  11. wENDY says:

    i CURRENTLY HAVE A sep WITH EQU-VEST. I AM NOT HAPPY WITH THEM. I AM CONSIDERING A SEP WITH VANGUARD OR FIDELITY. MAY I HAVE MORE THAN ONE SEP ACCOUNT…FOR INSTNCE, MAY I HAVE A FIDELITY SEP IN ONE YEAR AND A VANGUARD SEP IN ANOTHER YEAR? MUST I HAVE THE ACCOUNT IN PLACE BEFORE DECEMBER 31 OR DO I HAVE UNTIL APRIL 15 TO SET UP THE SEP?

  12. Wendy,

    In actuality, I think you can have more than one SEP-IRA, however, I believe that technically, you’re supposed to have one. I have been told that that’s the case from Schwab regarding Individual 401(k)’s.

    You should be able to open a new SEP IRA with another brokerage firm. I have been happy with Schwab, however, others have been happy with Vanguard and Fidelity.

    The more important issue is that the SEP-IRA counts toward your contribution limits on defined benefit plans (not roth or tradtional IRAs). See the detailed discussion at my blog for more on that or my shorter reply above. So you should be able to open a new SEP-IRA this year and contribute to it. However, if you have a 401k at another job, you cannot contribute more than 25% of your income to the aggregate of both accounts; i.e. SEP-IRA + work 401k must

  13. Trust Insight says:

    The easiest way to decide what options are best for you is obviously to ask a tax or investment professional. If you’d rather do it on your own, my best suggestion is research, research, research. Use any and every resource you have available…after all, this is your hard-earned money! Make sure you’ve at least skimmed the original sources (www.irs.gov). Then ask questions and research the parts that you don’t understand. Finding the right and legal ways to contribute to retirement can be very time consuming. This is why you should really decide how much your time is worth…Is it really worth it to spend so much of your time doing all this research? That’s why tax and investment professionals are out there…so you don’t have to get frustated and stressed. I suggest reading the following article from yahoo columnist Laura Rowley. She has many great points in all of her articles. http://finance.yahoo.com/columnist/article/moneyhappy/1151

    Of course my opinion on the subject is a little jaded (I work at a National Bank Trust & Asset Management Dept). If your situation isn’t that complicated, or you really just want to do it on your own…go for it! But do your homework before investing any of your money. If you decide to use a tax or investment professional…shop around, don’t just use the first one in the phone book! Ask for their rates, including annual and asset value fees. Also consider the resources available to them…they may have the best rates, but can they deliver the same product? The opposite is true with banks or investment companies that are too big…they don’t have the time or don’t care to give you the personal attention that you need.

    One last comment, http://www.sharebuilder.com has just announced that they will be providing small business 401k plans. They also have taxable investment accounts, IRAs, and College savings accounts, with different plans available. They have $4 automatic stock and ETF trades. Vanguard offers Target Retirement Funds that target how long you have before retirement…it takes the work out of managing your retirement account.

  14. diggy says:

    does that mean you have to pay FICA twice? Once now (on the gross income) and again when you retire (on that income)?

  15. jim says:

    You only pay FICA the first time.

  16. shrub says:

    According to the IRS publication on retirement plans for small business, employers can deduct contributions to their employees SEP plan as a business expense. The publication states that a business owner deducts their own SEP contribution on their 1040. So the notion of expensing your own SEP contribution is not legit.

  17. Olden Atwoody says:

    What are possible investment vehicles for a SEP IRA? Do I have more flexibility than with a standard IRA? Can I invest in property (foreign OR US?), rare coins, etc?

    • jim says:

      It has all the same options as a standard IRA. Mine is with Vanguard and it’s one of their mutual fund accounts.

  18. RITA BAGOT says:

    does it cost anything to open AND maintain a SEP-IRA….does Vanguard charge a fee or a percentage to open one and do they charge an administation fee>
    Thanks

  19. Fun stuff says:

    @Jim, you can have a self directed SEP, Traditional, Roth….etc and it can be invested in basically anything except Collectibles, like antique cars, rare coins stamps…etc. But there are some rules with family members and personal residence restrictions.


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