From selling things online to making deliveries, side hustles are becoming an increasingly common way for people to earn some extra cash. However, if you earned more than $400 last year, the IRS will have their hand out waiting to get their cut via taxes.
Most people don’t realize it, but because you essentially have a second income, you’re allowed to set a portion of it aside for retirement – just as you would with your primary job. By doing so, this can also help significantly reduce your tax bill for the year.
Both can be accomplished by utilizing what’s known as a SEP IRA. In this post, we’ll talk about how a SEP IRA works and why using one can help lower the taxes on your side hustle earnings.
What Is a SEP IRA?
SEP IRA stands for “Simplified Employee Pension Individual Retirement Account”. It effectively works just like a regular traditional IRA where you’ll make tax-deferred contributions. Over time, time, those investments will grow thanks to compounding returns. Once you reach the age of 59-½, you can then begin taking penalty-free withdrawals.
Every dollar that you save into a SEP IRA is one less dollar that gets taxed. Therefore, the closer you come to maximizing your contributions for the year, the more you’ll ultimately save.
Who Is Eligible to Use a SEP IRA?
SEP IRAs can be utilized by anyone over 21 years of age who’s earned more than $750 in 2023. This includes those who are:
- Self-employed
- Owns a small business
- Works for a qualifying small business
What’s interesting is that even if you work full-time at a normal job but earn a little extra money on the side, the IRS considers you to be self-employed. That puts you in a unique position to contribute to more than one retirement plan if you wish. For example, in a single year you could contribute to:
- Your employer’s 401(k)
- Your personal Roth IRA
- A SEP IRA
Not only would that result in a lot of deferred taxes, but it would also help to quickly accelerate the growth of your retirement nest egg.
How Much Can I Contribute to a SEP IRA?
SEP IRAs have an interesting contribution structure. The easiest way to understand them is to compartmentalize the contributions into two main categories: Employees and employers.
With employee contributions, your SEP IRA is essentially just another traditional IRA. In 2023, you were allowed to save up to $6,500 or $7,500 if you’re age 50 and older. However, you’re not allowed to exceed this limit across the sum of your IRAs. So for example, if you already put $6,500 into a Roth IRA last year, then you can’t make an employee contribution to your SEP IRA.
Because you’re considered to also be self-employed, you have the opportunity to make additional contributions to your SEP IRA as your own employer. This amount is far more generous than the employee contribution limit. As of 2023, it’s the lesser of up to:
- 25 percent of your net earnings
- $66,000
For instance, if you earned $20,000 of net income this year doing odd jobs, then you’d be eligible to save up to $5,000 into a SEP IRA.
What Investments Can I Have with a SEP IRA?
SEP IRAs offer basically the same range of investment options as any other IRA. You’re only limited by what the brokerage you choose to use makes available.
For most financial platforms, this should enable you the ability to purchase:
- Stocks
- Mutual funds
- ETFs
- Bonds
- REITs
- Etc.
You can even hold cash or cash-related investments such as CDs if you’re more risk-averse.
How Does a SEP IRA Reduce My Tax Bill?
Contributing to your retirement savings is a great way to build long-term wealth. However, even if that’s not at the top of your priorities, most people with side income should still consider using a SEP IRA for the powerful tax savings that it can offer.
When you take a portion of your earnings and decide to put them into your SEP, they get deducted from your taxable income income for the year. Depending on how much money you earn, that can amount to some pretty incredible savings.
For example, take someone who’s earned $20,000 for the year from one or more side hustles. Under normal circumstances, if we assume that they’re in the 24% tax bracket, then they’d owe approximately $4,800 in taxes on this income.
However, consider what would happen if that individual maxed out the employer contribution to their SEP IRA. In this case, that would be $5,000 – leaving them with only $15,000 of taxable income. Now their tax bill would be reduced to approximately $3,600. That’s a $1,200 decrease just for the act of saving for retirement.
Can I Have a SEP IRA and Other IRAs?
Yes, you’re allowed to have a SEP IRA in addition to traditional or Roth IRAs. This is of course assuming you meet the IRS income and other eligibility requirements to have these other types of IRAs.
Again, remember that for employee contributions to a SEP IRA, the annual total amount you contribute across all of your IRAs cannot exceed the IRS limit. For 2024, this cap has been increased to $7,000 or $8,000 if you are age 50 and older.
Where Do I Open a SEP IRA?
Most (but not all) financial institutions that offer retirement plans will usually have SEP IRAs available. This generally includes brokerages, trading platforms, banks, credit unions, mutual fund companies, etc.
Before choosing your provider, it will be important to consider such factors as fees, investment options, customer service, and management ease. Although some financial institutions may charge account maintenance fees for SEP IRAs, most are happy to give you an account free of charge. If you prefer to be more hands-off with your accounts, then it could be helpful to choose a provider that offers financial advice (typically for a fee).
Is a SEP IRA Right for You?
When it comes to SEP IRAs, there’s not much to dislike. On one hand, you get the opportunity to pump more money into your retirement nest egg which helps accelerate your net worth. On the other hand, you’ll end up saving yourself potentially thousands in taxes by not having to pay the IRS as much as you originally were required.
Of course, the most difficult part of using a SEP IRA is having to make one large contribution. This can be especially difficult if you’ve already used your side income earnings for other purposes. For this reason, we recommend planning ahead by setting aside a small amount each month. You can work this into your budget, and that will make contributing to your SEP IRA a lot easier the following year.
No matter how you go about it, a SEP IRA can be a powerful tool for building a robust retirement savings plan. The sooner you start taking advantage of it, the more you’ll keep for yourself by avoiding taxes and putting those earnings towards a brighter financial future.
Featured image credit: Pexels
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