SEP IRAs for Digital Nomads

SEP IRAs are an amazing way for self-employed digital nomads to defer some of their income from taxation and build their retirement savings. I’ve touched on SEP IRAs in some of my previous postings, but never really got into the nitty gritty of what they are and how they can be advantageous to digital nomads, such as ESOL teachers. This week, I’m going to break it down for you.

What is a SEP IRA?

SEP stands for Simplified Employee Pension and IRA stands for Individual Retirement Account. Last week, we talked about Roth and traditional IRAs. This week, we’re going to focus on SEPs. A SEP IRA is very similar to a traditional IRA in that the money deposited is pretax money and grows tax free. Any distributions that you take on your SEP are taxable as income in retirement. In most cases, you cannot withdraw from your SEP without a penalty until age 59 and a half. Like a traditional IRA, most people need to start taking required minimum distributions (RMDs) from their SEP retirement account by age 70 and a half.

What makes a SEP different?

A traditional IRA is one where you contribute your own earnings and deduct this from your taxable income. Contributions to a SEP IRA are made by your employer. In this case- you are your employer. You are able to contribute a percentage of your income to your own retirement. This money is a business expense, but the account belongs to the employee and grows tax free.

What are the contribution limits?

This is where SEPs are awesome! You can contribute 25% of your salary up to $56,000 per year to a SEP. Remember that your traditional and Roth contribution limits are only $6,000 per year. If you are a believer in FIRE and planning to retire early, $6,000 per year in savings is not going to get you very far. Maxing out your SEP IRA is a great way to ensure that you have adequate savings to retire- and hopefully retire early! For more information on the contribution limits on different types of IRAs, including SEP IRAs, check out this incredibly informative post from The Entrust Group

I run my online teaching business as an S-Corp, so let’s use that as an example. As CEO/President/Director (whatever you want to call yourself), I pay my sole employee (me) a wage and make a contribution to my employee’s (me again) SEP IRA.

 

Having your investments grow tax-free is a huge advantage!

Let’s look at an example below:

Total Revenue: $3,000

Employee Expense: $2,000 (This the wage you pay yourself.)

SEP IRA Contribution: $500 (This is calculated as follows: $2,000 X 0.25 = $500)

If you are making more money, you can contribute a larger sum to your SEP. Just remember that it can’t exceed 25% of your income or $56,000- whichever is LOWEST.

Is there any other catch?

Yes, you have to make sure that you set up a SEP for each eligible employee and that you make equal contributions as a percentage of salary. If you are a one-person operation (which you likely are), then this is not an issue.

 

Running your income through a company allows you to pay yourself a wage, but you can still contribute to a SEP even if you are a sole proprietor.

What if I don’t run a company?

I run my teaching business as an S-corp, but you don’t have to. Many American digital nomads are considered sole proprietors- that is, they file a Schedule C at tax time. You can still contribute to a SEP in this case. The same contribution limits apply, but they will apply to your net self-employment income. Check the IRS website for a good link on how this is calculated. When you first get started, it’s always a good idea to sit down with a CPA and work through the process together.

How do I set up my SEP?

Most brokerage houses can help you to establish your SEP. This is a process that includes completing IRS Form 5305-SEP. I have personally used Charles Schwab and been very satisfied with the service they’ve provided. However, you can do this at many different financial institutions- Vanguard and Fidelity come to mind. There are custodian fees associated with my account, but they are incredibly low and taken directly from my account each year.

How do I contribute to my SEP IRA?

I use online bill pay each month to send a deposit to Schwab, and a few days later the money shows up in my account to invest as I choose. I can say the process to set up a SEP is incredibly easy, and I have a great deal of flexibility. I am able to max out my SEP contributions each month. However, if I did not have adequate cash flow, I could choose not to contribute for a particular month.

 

A SEP offers another source of income in retirement.

How does a SEP IRA impact my ability to contribute to my own IRA?

This gets a little tricky. The money that you contribute to your SEP IRA as an employer may impact your ability to contribute to a traditional IRA. Technically, your SEP is considered a retirement plan at work. However, it does not impact your ability to contribute to a Roth IRA. If you are able to make regular contributions to your SEP on your own behalf (not as an employer- but rather as an individual), your ability to contribute to your personal IRA (Roth or traditional) will be reduced. However, if you keep your SEP IRA strictly for employer contributions, then you can still contribute to your Roth. Check out the IRS website for more details.

Final Thoughts

One of the major drawbacks that digital nomads, particularly online teachers complain of is the lack of benefits. Living life on the road is awesome, but going without a pension definitely creates anxiety for the future. The best way to be prepared for retirement is to save early and often. A SEP can help you to do that. Many digital nomads aren’t making enough to max out their SEP and take advantage of the $56k tax deferred retirement savings. However, there are still real tax benefits to utilizing this investment tool. Let’s end with a very simple illustration.

If you pay yourself $1,000 per month in salary, you are able to contribute $250 per month to your SEP IRA. This money grows tax free until you choose to retire. Let’s assume that you make the contributions for the length of your career. We’ll assume you work for 30 years.

Assuming a very conservative 5% annual rate of return, that $250 per month will have grown to $208,931 by the end of the 30 years. It may not be enough to retire off of, but it is a nice nest egg to be able to draw on.

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