SEP for the Self-Employed

Mar 28, 2023

Simplified Employee Pension

The Simplified Employee Pension (SEP) is a great way for the self-employed to save for retirement.  There are several ins and outs with a SEP, and I want to go over the main ones.  My focus is on the self-employed, as the SEP rules are different for the corporate employee. 

I have written a separate piece about the SEP when used for small businesses.  

Only Employer Contributions

Money goes into a SEP from only one source:  the employer.  If you own your unincorporated business, you are employed by yourself.  There is no opportunity for employees to defer into the SEP as there is in a 401K.  There are old SARSEPS out there (salary reduction SEP) still functioning, but new ones haven’t been available for years. 

The SEP is ideal for a one-person company or a small shop with few employees.  The reason?  Contributions go into the SEP as a percent of company profits, up to 25%.  Whatever percent contribution the business owner makes for himself must also be made for all participating employees.  If he or she has a small family business this may not be much of a consideration.  But do owners also want to maximize contributions for the receptionist? 

There is Now a Roth Option

The Secure Act 2.0 now gives a Roth option for SEP contributions.  This means that these contributions will be recognizable as income on the participant's tax return.  

Five Tax Forms Involved!

I’m going to refer to several different tax forms in this piece because I want my readers to get the flow of how the SEP works.  These are the 1040, Schedule C (Profit or Loss from an unincorporated business), Schedule SE (Self-Employment tax), and 1040 Schedules 1 and 2 (Adjustments to income). 

Say your business has $100,000 of profit, and you are a sole owner.  That profit shows up on line 31 of your Schedule C.  Line 32 tells you to transfer that amount over to Schedule SE and to Schedule 1.

Schedule SE is the form that calculates self-employment tax.  This is Social Security and Medicare tax for the self-employed.  For corporate employees this is called FICA tax, and consists of 7.65% - 6.2% Social Security and 1.45% Medicare.  This amount is deducted from the employee’s pay, the company matches it, to total 15.3%, and makes periodic deposits to the Treasury. 

For the self-employed there is a series of adjustments, taking the total tax down to 14.13%.  This is what’s calculated on form SE Line 12.  The total SE tax due transfers over to Schedule 2, Additional Taxes, and then over to the 1040.  One line 13 the SE tax is cut in half, and that halved amount goes to Schedule 1 line 15as an adjustment to taxable income - meaning you, the self-employed owner, pay both the employer and employee side of these taxes, but deduct half of it from taxable income. 

The SEP contribution itself goes on Schedule 1 line 16 as an adjustment (reduction) to taxable income.  Very important NOTE:  the maximum SEP contribution is not 25% of profit – it is 18.59%.  As with the SE tax there is a series of adjustments, so the maximum contribution the business owner can make for himself is 18.59% of profit. 

All your Schedule 1 adjustments go on to the 1040, and the ultimate tax is calculated.  This is a lot of forms.  But let me give you a quick visual of the flow of it. 

A Quick Visual

We’ll start with the assumption of $100,000 profit from self-employment being the only income on this tax return, the client is married filing jointly for the 2022 tax year, and no SEP contribution is made.

$100,000         taxable income from Schedule C to Schedule 1

-$7065             deduction of ½ of SE tax from

-25,900            standard deduction married filing jointly

$67,035           taxable income

$7633              Federal income tax payable using tax tables

$14,130           add total Self-Employment tax, from Schedule SE to Schedule 2

$21,763           Total taxes payable

Now let’s look at the same thing again only this time with a maximum SEP contribution of $18,590.

$100,000         taxable income from Schedule C to Schedule 1

-$7065             deduction of ½ of SE tax from

-$18,590          SEP contribution

-25,900            standard deduction married filing jointly

$48,445           taxable income

$5402              Federal income tax payable using tax tables

$14,130           add total Self-Employment tax, from Schedule SE to Schedule 2

$19,532           Total taxes payable

The result?

What’s the tax result?  A savings of $2231.  The way to think of it is this:  That amount is going to leave your  checking account, one way or another.  With no SEP contribution, it does to the US Treasury.  With a SEP contribution, it remains in your pocket. 

OR – another way to look at it is this:  Your $18,590 SEP contribution only cost you $16,359 to make. 

Employee contributions go on Schedule C

Notice that the SEP contribution does not affect the SE tax because, for the owner alone, it is not a business deduction on Schedule C but rather an adjustment to income on Schedule 1.  

Now say you do have an employee you're covering under a SEP.  Where do contributions to that employee go?  On Schedule C, and the max is 25%.  You the business owner are the one whose contribution is limited to the 18.59% - not the employees.  They can get a contribution of 25% of their W-2 income.  You made that SEP deduction on the Schedule C - the same place where you deduct employee wages.  With employee contributions there is a double tax savings - you've reduced the flow-through Schedule C income to your own taxes, and reduced the business profit that flows through to the Schedule SE - meaning you've reduced the self-employment tax as well.  

For more information please see my earlier post on SEPS here.  Best to all,

Glenn J. Downing, MBA, CFP®

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