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Retirement Perspectives

The answer for many people is yes, thanks to a special type of IRA known as SEP—but there are a number of rules to be aware of. Here’s our handy guide.

Americans are an entrepreneurial lot. Many people have side businesses in addition to their full-time jobs. Can they contribute the income from these activities to multiple retirement accounts? It’s a question that I am often asked. The short answer is yes. The opportunity to enhance your long-term retirement savings is significant—but make sure you understand the maze of rules.

According to Intuit, more than one in three persons in the U.S. labor force work for themselves—and this figure is expected to grow to 40% by 2020. Increasingly, workers are supplementing the traditional nine-to-five day job with independent work, supplementing their income with “side hustles.” The well-documented rise of the “gig economy” (e.g., Uber driver, mobile app developers, etc.), is changing the way Americans save for retirement.

There are numerous options to build an extra nest egg. Here is probably the most common example: an individual enrolled in an employer’s 401(k) plan would like to fund a Simplified Employee Pension (SEP) IRA using income derived from a side business. Let’s explore that scenario.

SEP IRAs: The Basics
SEP IRAs were designed to provide self-employed individuals with the ability to save for retirement on a tax-deferred basis. SEP IRAs may also appeal to business owners who want to help their employees save, but who do not want the administrative and fiduciary responsibilities of a qualified plan. Instead, SEP IRAs are low-cost, surprisingly easy to set up and maintain, and allow the plan sponsor (owner) to make discretionary contributions, based on the financial footing of his or her business. For business owners, the contributions they make to their own SEP IRA account generally is tax-deductible.

The first checklist item for a SEP would be to confirm that the business(es) you work for have no common  control or affiliated relationship. Partner with a knowledgeable tax and or legal professional for assistance in determining whether you satisfy the common control or affiliation standards otherwise known in IRS parlance as “Controlled Group” or Affiliated Service Group”

For our purposes, we will assume that the businesses are not part of a controlled group. So, as long as firms are not affiliated, the contribution limits for, say, a 401(k) and SEP IRA are independent of each other. Under Section 415(c) of the Internal Revenue Code (IRC), that means you can contribute up to $55,000 per employer in 2018 ($56,000 in 2019). However, salary deferral limits under IRC 402(g) that apply to 401(k) deferrals (Roth and pre-tax) are per individual. In 2019, the maximum deferral limit regardless of the number of jobs is $19,000 ($25,000 including  age 50-plus catch-up).

A SEP is generally the best option for an individual who already has maxed out his or her 401(k), 403(b), or SIMPLE IRA through his or her full-time job. Why? SEP funding would be done solely with employer contributions, for which the limit is generally the lesser of 25% of eligible compensation, or $56,000 (2019). Said another way, you could fully fund a SEP IRA (using side-business income) even if you’re covered by a 401(k) at your day job. In 2019, for example, an eligible individual can save up to $112,000 ($118,000, including 401(k) age 50 catch-up) in a SEP and 401(k).

Tip: It’s remains possible to establish and fund a 2018 SEP contribution as late as business tax filing plus extension!

How Might a SEP IRA Work?
Suppose Charles, 49, works for LMNOP Inc., and defers $19,000 of his salary from his primary job into his 401(k) account. His employer contributes another $37,000 (representing a total of $56,000 through a combination of match and profit sharing contributions). Charles also has a “side hustle” where he is the sole proprietor of a consulting business. There is no common control between his consulting firm and LMNOP Inc. Charles can fund his SEP IRA up to the lesser of 25% of compensation, or $56,000. (See our SEP calculator for contribution amounts).) In addition, Charles continues to be eligible to fund a traditional IRA or Roth IRA ($6,000 in 2019), assuming his income qualifies. However, the traditional IRA contribution may not be tax deductible.

Establishing a SEP IRA
Any employer, including self-employed individuals, can establish a SEP. Notably, employer contributions can be commingled with traditional IRA accounts, but not with Roth IRAs or SIMPLE IRAs. However SEP IRAs can be converted to Roth IRAs at any time, although the transaction would be subject to income tax.

Receiving a SEP allocation does not affect the amount an individual can contribute to a traditional or Roth IRA, although the investor may be not be able to realize a tax deduction as he or she could with a contribution to a traditional IRA. In other words, receiving a SEP contribution could prevent an investor from making a deductible contribution to a traditional IRA; whereas, Roth IRA contributions are always made on an aftertax basis. 

Establishing a SEP IRA is straightforward. In most cases, an individual (business owner) completes IRS Form 5305-SEP, while eligible employees establish their own individual SEP IRA. Workers generally are eligible to participate if they are at least 21, worked for the business in three of the last five years, and earned at least $600 for the year.

SEP IRAs can be established and funded as late as the business's tax-filing deadline plus extension. For example, businesses have at least until April 15 to establish a SEP IRA for 2018, and as late as October 15, 2019, if they are on extension.

Employer Eligibility
Virtually any type and size of employer can establish a SEP IRA, including corporations, partnerships, self-employed, LLCs, and nonprofit organizations. If an employer establishes a SEP by using Form 5305-SEP, the IRS requires that the SEP be the only retirement plan offered by the business.

Tip: Take caution when you and/or certain family members own a related business, as SEPs are subject to controlled-group rules. If you or family members own a controlling interest in another business, employees of that other business may need to be included in the SEP, assuming eligibility rules are satisfied.

Contributions
SEPs are funded solely with employer discretionary contributions. Contribution limits are generous, allowing an owner to shelter and potentially deduct 25% of compensation or $56,000 (whichever is less) in 2018. There is a slight increase to $56,000 for 2019. Although SEP contributions are discretionary, they must be based on a written allocation formula. Further, all contributions must be fully vested upon receipt.

Tip: All SEP contributions must be deposited into a traditional IRA established by the employee. SEP contributions cannot be contributed to a Roth or SIMPLE IRA.

Reporting
Employers simply report SEP contributions on a business’s tax return. For individual participants, the IRA custodian reports SEP IRA contributions on IRS Form 5498 and distributions on IRS Form 1099-R. Keep in mind that the custodians report contributions in the year they are received. If an employer makes a 2018 contribution in 2019, the amounts reported by employees on their individual returns may not coincide with the employer’s filing. Employers are advised to keep their own records of SEP contributions.

Rollovers
When it comes to rollovers, SEP IRAs, like traditional IRAs, are versatile. A SEP IRA account can be transferred tax free to another SEP IRA at any time. Moreover, an individual can roll over a 401(k), 403(b), or governmental 457(b) into a SEP IRA, and vice-versa.

Converting to a Roth IRA
A SEP IRA can be converted into a Roth IRA, subject to the same rules as a conversion from a traditional IRA. Therefore, as with a traditional IRA conversion, the amount of the SEP conversion is subject to federal and state taxation, but not the 10% early-withdrawal penalty.

Tip: Effective January 1, 2018, the Tax Cuts and Jobs Act repealed the ability to recharacterize Roth conversions. Therefore, a conversion to a Roth IRA is irrevocable.

Required Minimum Distributions
As with traditional IRAs, SEP IRA account owners are required to take a minimum distribution the year they turn age 70½. The required minimum distribution (RMD) rules permit the initial minimum distribution to be deferred until April 1 of the following year. Delaying an RMD requires the account owner to take two RMDs the following year.

Tip: An individual 70½ or older is eligible to participate in a SEP, assuming eligibility requirements have been satisfied. However, the individual also must take minimum distributions.

Getting in Step with SEP
While SEP IRAs offer some attractive features, including ease of use and cost-effectiveness, business owners are urged to consult with their tax professionals to make sure that a SEP is the right choice for the business owner’s particular situation. It should be noted that businesses that fund SEPs now may roll over the balance to a qualified plan that is established later, if that is the preference.

A SEP IRA can be a powerful tool in helping sole proprietors supplement their retirement savings. As with traditional IRAs, contributions to SEP IRAs, and the earnings they realize, are tax-deferred until withdrawal. SEPs retain the distribution rules that apply to traditional IRAs. Of course, with opportunity comes responsibility, and with SEPs, individuals are given sole responsibility for deciding how to manage their retirement accounts. Financial professionals are well positioned to both advise employers on establishing SEP IRAs and workers on how best to manage them.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

Simplified Employee Pension plan, commonly known as a SEP IRA, is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP IRA plan for your business, you and any eligible employees establish your own separate SEP IRA; employer contributions are then made into each eligible employee’s SEP IRA.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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