If you're a small employer, setting up a 401(k) plan can be time-consuming and overly complicated, but a Simplified Employee Pension (SEP) plan lets you offer your employees the benefits of a retirement plan without the complexities of a 401(k). To make the most of these plans, you should consider maximizing your contributions. Here is an overview of the essentials to point you in the right direction.
Maximum SEP Contributions for Tax Year 2020
In 2020, if you set up a SEP plan for your employees, you can contribute 25% of their income up to $57,000. Generally, that number increases every year.
To give you an example, if you pay an employee $100,000 per year, you can contribute $25,000 to their SEP. In contrast, if you have an employee earning $300,000 per year, 25% of their income is $75,000 so in this situation, you have to stick to the $57,000 maximum.
SEP Contributions for the Self Employed
SEP plans aren't just for employers to fund employee pension plans. If you're self-employed, you can set up a SEP for yourself. Again, you can only contribute 25% of your income up to the yearly maximum, but the calculations are slightly different for self-employed people.
In particular, you have to base the 25% contribution on your net income. That is your self-employment revenue minus your business expenses and depreciation costs, and you have to include SEP contributions as part of your business expenses. As a result, you typically can invest just under 20% of your gross self-employment income to your SEP plan.
The Benefits of Maximum Contributions
You receive a business deduction for SEP contributions. To explain, imagine your business has $257,000 in profits, and you contribute $57,000 to your employee's SEP plan. You receive a $57,000 tax deduction, reducing your profits to $200,000 on paper which helps to lower your tax liability. At the same time, your employee gets the benefits of a retirement account.
While the funds are in the SEP account, they grow tax-free. You and your employees don't have to pay any income or capital gains tax on the earnings in the account. Once you start making withdraws from the SEP, you face income tax on those payments, and if you make withdraws before the age of 59.5 years, you incur a 10% penalty.
Deadlines for SEP Contributions
If you don't have the funds to contribute to a SEP throughout the year, that is fine. The Internal Revenue Service (IRS) gives businesses ample time to make these contributions. You have until the due date for your tax return. Usually, that means making contributions by April 15th, but if you file an extension, you have until October 15th of the year following the year for which you are filing your tax return.
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