We freelancers pay a lot of tax. We don’t just pay an income tax rate of anywhere from 0 to 39% on our freelance income – we also pay a flat 15.3% self-employment tax, no matter what our income bracket. Without tax planning, this can be a huge bite.
As artists and cultural workers, our freelancer tax strategy is generally to reduce the amount of our taxable self-employment income as much as legally possible. Tax planning is hard, because it’s about saving small bits in many places. There are few silver bullets. But the closest thing there is to a silver bullet is tax-sheltered retirement savings. There are many tax shelters, with a range of limits, but the biggest contribution caps tend to be in retirement. Why? It takes a lot of money to retire, and if you don’t pay for yourself, and your children can’t, the government is going to have to. They put a big incentive there to sweeten the deal of saving for your retirement.
There are a bunch of different retirement plan options. Most people have heard of the 401(k) (and its non-profit employee twin, the 403(b)). And most people have heard of the Individual Retirement Arrangements (IRAs) – the Traditional IRA (tax-free now, taxed upon withdrawal) and the Roth IRA (taxed now, tax-free upon withdrawal). And there are a host of others (among them the SIMPLE and the “solo 401(k)”). But today I’d like to focus on my favorite one, the Simplified Employee Pension (SEP).
What is a SEP?
A SEP is two things. It’s an amazing high-limit retirement plan for the self-employed. In other words, it’s a tax shelter with a super high allowance for socking away money tax-free. And at the same time, it’s a pension plan for your employees, if you have them.
First, let’s talk about the self-employed retirement plan/tax shelter part. If you never plan to hire an employee, this is the only part you need to worry about.
Most importantly, the SEP has a fantastic contribution limit. You can put up to 20% of your self-employed income into it, where it grows tax-free. The maximum yearly contribution is $53,000. This means that if your income goes over $265,000, you will be putting in less than the full 20% of your income ($53,000 is 20% of $265,000). Let’s pause on this piece of great news. You can shelter 20% of your freelance income from taxes. While saving for your retirement. Hallelujah.
Another wonderful thing about the SEP is that it is super flexible. You can contribute whatever percentage you want – or none at all – each year. This is great for the highly variable income of freelancers. In tight years you can do nothing, and in flush years, you can stash away a high percentage of your taxable income.
It’s also easy and generally free to set up and maintain. I set up my own SEP almost by accident – I was on the phone with my bank for something else, mentioned that I was thinking of opening a SEP, and they just did it right there in about one minute. Some plans, like the solo 401(k), require a lot of paperwork and due diligence both to set up, and to maintain each year. So the simplicity of the SEP is a huge plus.
Here’s the second thing about a SEP—It’s a pension plan for your employees. Pension is a quaint word in this “me first” era of abandoning the principle of a greater good. Companies used to take better care of their workers, and the pension was a big part of that. So I’m a fan.
The SEP allows you to set up savings for your employees (a pension). Here’s how it works. You, the employer, contribute to your employees’ plans – they are not allowed to put money into their own SEP. You must apply the rules equally to all employees. And it’s important to note, that as a self-employed person, you are also an employee. You can put up to 25% of each employee’s pay into the SEP, not to exceed $53,000 to any one employee in a year.* As the employer, what you contribute to the employees’ SEPs is a tax deductible expense for you. For you, the SEP is nice because it is a low to no-cost employee benefit plan to start and to operate, and it’s available no matter what size your business. So it is a plan that can grow with you.
For your employees, it’s nice because they are immediately vested (in other plans, this isn’t the case). And they are entitled to your contribution in the same percentage as all other qualified employees, even if they quit before the year end.
Beware of that last point. The corollary is, you have to pay the same percentage to each employee. That includes yourself. So if you want to max out the contribution you make to your own retirement, and you have a bunch of employees, you must factor into your expenses the cost of contributing that same percentage to each employee. It doesn’t apply to contractors (see the rules on the employee/contractor distinction). So remember to think carefully about how your business might grow – your need for employees and your ability to budget this in. But it’s good to note that you can also discontinue the SEP at any time.
So here are the key takeaways to remember for the SEP:
- It takes two minutes to set up and is easy to maintain.
- You can contribute up to April 18, 2017 to count for your 2016 taxes.
- You can put away a massive amount of income – up to 20% of your self-employment income up to $53,000. This is good for your retirement security, but also great for reducing your self-employment tax and income tax now.
- You can put away the max in good years, and little or none in bad years – a good choice for freelance cash flow issues.
- A great thing to have for your employees. It’s an incentive, and something good for the world. Just remember that if you make a contribution to your own retirement through a SEP, you must contribute that same percentage to each of your employees.
*You may have noticed that you are only allowed to contribute 20% to yourself, but you may contribute 25% to your employees. That’s because as a self-employed person, you get to deduct the cost of your own SEP contribution from your self-employment income. Effectively, this reduces your actual percentage allowance to 20%. Proof: $50,000 of SE income x 20% = $10,000. ($50,000-$10,000) x 25% = $10,000.
DISCLAIMER: True tax advice is a two-way conversation, and your accountant needs to hear your full situation to apply the rules correctly in your case. This post is meant for general information only. Please don’t act on this alone.