Less Tax vs Higher Pension Contribution

June,

I am employed full-time but have been a part-time indie for the last 20 years (consulting psychologist).

My question is about my SEP IRA. One of the problems, as I see it, with a SEP IRA is that the more you deduct from your gross self-employment income, the LESS you can contribute because the allowable contribution is a percentage (20 or 25%?) of your self-employment income AFTER expense deductions.

It would seem that the less you deduct for expenses, the more you can save!

How does one crunch the numbers to see what the best way to go is?

By the way, how would you rate the SEP IRA vs the new Roth 401(k)?

Mark
Fairfax Station, VA


Dear Mark,

Good questions. You are into the "indie business mindset" way of thinking.

Let me overview here for some of my readers. The allowed contribution to any pension plan for a self-employed is limited by the net self-employed income. Therefore the more business expenses you have the less your net income and so the less you may contribute to your indie pension.

Here are some actual numbers to look at: Let's assume a 15% federal income tax and 15% SE tax. That means that deducting a $1,000 expense saves you $300 -- 30% X $1000.

In a SEP, because your self-employed income was reduced by $1000, you may contribute $200 less to your pension.

You are looking at a tax savings of $300 versus putting $200 less into your pension.

It makes more sense to take the tax savings and do one of two things:
1. Put the $300 into another kind of non-pension savings. Talk to your investment broker about what would be best.
OR
2. Change to a different kind of indie pension. There are many to choose from, and at my earliest opportunity I will write about the choices you have. Fort the interim, ask your personal tax advisor to explain your choices.

You can have ROTHs of any kind, e.g. SEP, 401-K. The younger you are and the less concerned you are about paying less tax NOW the more advantageous a ROTH.

Best,
June