If you make any sort of sizeable freelance income like I do, then you’re probably already aware that you will owe taxes on all that money you’ve earned.
However, I’ve discovered a really neat trick. I’ve found a really simple way to reduce my taxable earnings as well as save even more for retirement than I already was – and all I had to do was open a Vanguard SEP IRA.
The results – this year I’ll save over $1,000 in Federal taxes that I would have otherwise paid had I not known about this technique.
If you’d like to help yourself to some pretty significant tax savings, then let me introduce you to the concept of the SEP IRA and explain how the brokerage company Vanguard helped me in setting one up.
What is a SEP IRA?
A SEP IRA is short for a “Simplified Employee Pension Individual Retirement Arrangement”. Basically for all intensive purposes, a SEP is the same thing as a regular traditional IRA with the same sort of rules regarding deductions, tax-sheltered investment growth, and no withdrawals until age 59-1/2.
However, there’s one big difference: Because you made money on your own, the government treats your “business” as if you are self-employed. Therefore since you are your own employer, you have the option to contribute money to yourself to help save for retirement.
How much? Employer SEP IRA contributions can’t go over the lesser of:
- 25% of the employee’s total compensation
- $53,000 for the 2015 tax year.
Now for the best part: Employer contributions are deductible as a business expense. Why is that good? Because now you’re reducing the amount of money that gets used to calculate how much in taxes you’ll have to pay-in to the government.
Suppose you earned $20,000 last year in freelance income after applicable expenses. If your house is in the 25% tax bracket, then you’d owe $5,000 in taxes.
However after reading this article, you decide to contact your tax preparer and max out your SEP IRA contribution. You’ll add in 25% of your $20,000 into a SEP IRA for a total of $5,000. Now you’ve reduced your taxable income down to $15,000 since you gave $5,000 of it to yourself for retirement.
Now your taxes will be closer to 25% x $15,000 = $3,750. That means you saved yourself $5,000 – $3,750 = $1,250 in tax payments. Nice work!
What About Employee Contributions?
With a SEP IRA you are also allowed to contribute to the account as an employee as well. As of 2015, your contributions cannot exceed $5,500.
But here’s the bad news: If you already contribute to a different IRA like a traditional or Roth, than forget it. When it comes to IRA’s, you can only contribute UP TO $5,500 altogether, not in each account.
That’s why the employer contribution part is such a beautiful thing. By using a SEP IRA you’re saving even more for retirement above and beyond what you’re already contributing to your 4101k and IRA accounts.
Why Get a Vanguard SEP IRA?
Vanguard has been the place I’ve used for years when it comes to managing my retirement funds.
You could actually open a SEP IRA pretty much anywhere that offers them. However I do almost all my major brokerage investing with Vanguard, so I choose to go with them without a second thought.
Plus when you consider that their funds are among the cheapest and most highly regarded accounts out of all the available mutual funds out there on the market, there’s really no competition.
When I had first heard about a SEP IRA and wanted to see if I was eligible to contribute to one, I was very impressed with Vanguard’s customer service. With one 15 minute phone call I learned more about how a SEP IRA works and the rules than if I had poured hours into doing research myself over the Internet.
After working with my tax-preparer to figure out the exact amount that I was eligible to contribute, Vanguard helped me to setup the account within minutes. It was a very simple process.
If you’d like to open one up for yourself, the eligibility requirements are that:
- Employees must be allowed to participate if they are over age 21
- Earn at least $550 annually in 2014, or $600 in 2015
- Have worked for the same employer in at least three of the past five years.
Another cool feature about a Vanguard SEP IRA: Other than your mutual fund expense ratios, the maintenance of this account is completely free (the same cannot be said for a Solo 401k). If you do any other significant investing with Vanguard or sign-up for paperless communications, you can also avoid a $20 per year fee.
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