If you've decided to fight the man and start your own business, you don't have to forgo the generous contribution limits of an employer-sponsored retirement plan used to reduce your taxable income. You can take control yourself and start a simplified employee pension (SEP) for your self-employment income and partake of similar benefits.
Starting a SEP
Starting a SEP requires a formal plan document, informing employees, and setting up an account for each eligible employee. It sounds complicated, but one look at the IRS template plan, the Form 5305-SEP will show you it’s really quite simple, especially if you don’t have any employees. When you start the plan, you need to give a copy of the plan rules to all of the employees and keep them informed of any changes to the plan. If you are self-employed, don’t forget to give yourself a copy of your plan rules and keep yourself informed of any changes you make to the plan.
SEP Contribution Limits
The maximum contribution to a SEP IRA for a self-employed person is 20 percent of your profits from self-employment. Your net self-employment income is essentially your take-home pay: your revenues minus any deductible self-employment expenses. However, you can only count income from the business for which the SEP is set up when figuring your maximum contribution. For example, if you have a freelance writing business for which you set up the SEP IRA, you can’t use income from your day job as a firefighter to increase your contribution limit.
Money you squirrel away into your SEP does not get included in your gross income. You get to claim the deferral as an above-the-line deduction, which means you can take it even if you don't want to itemize. For example, if you pay a 28 percent tax rate, a deferral of $10,000 into your SEP IRA would save you $2,800 on your tax bill for the year. In addition, all the money you earn in the SEP grows tax-free until you take distributions.
Warning: Beware of Your Employees
If you have employees in your self-employed business, you will have to create SEP accounts for them, too. In addition, you have to fund them at the same rate as you fund your own SEP, which could make the plan much more costly than anticipated when you started it. Though you can set less restrictive standards, at a minimum you must cover all employees who are at least 21 years old, have worked for you for any part of three of the past five years, and who received the minimum compensation, which is $550 in 2012.