04/01/2014 05:33 pm ET Updated Jun 01, 2014

How to Reduce Last Year's Tax Bill by 25 Percent

Imagine being able to reduce your 2013 taxable income by up to 25 percent. If you are self-employed or a solopreneur, you may be able to reduce last year's taxable income by as much as 25 percent or $51,000 -- whichever is less. Here's how:

The IRS allows small businesses, even those with as few as one employee (you), to establish retirement plans. Depending on the type of plan you may be able to make a tax deductible contribution for the previous year at any time between January 1 of the new year and your tax filing date -- April 15 for most people.

There are many types of retirement plans a small business can set up. Which plan is best for you depends on the size of your business, how much you intend to contribute, and other factors. This post focuses on the Simplified Employee Pension, or SEP.

Simplified Employee Pension

A Simplified Employee Pension or SEP is a small businesses retirement plan that allows employers to make pre-tax contributions of up to 25 percent of the employee's salary. Contributions may be made at any time during the calendar year. Contributions may also be made in the following tax year right up to the tax filing deadline.

For many self-employed people, the tax filing deadline is April 15. If you file an extension, you have six more months to submit your tax return and fund your SEP retirement plan.

For the sake of simplicity, let's assume you file on time and that your tax filing deadline is April 15. Let's also assume that you are a true solopreneur or self-employed individual and have no employees. SEPs make great plans for larger small business as well, but to keep this post from getting out of hand let's focus on a business that has just one employee -- you.

Contributions to your SEP cannot exceed 25 percent of your net business income subject to a maximum contribution of $51,000. Here is how the math works: You make $100,000 in commissions, fees or other earned income from your business. Your contribution can be up to $20,000.

Yes, $20,000. Why $20,000 and not $25,000? Because the contribution limit is based on net income which includes gross income less business expenses. Your SEP contribution counts as a business expense. So... $20,000 is 25 percent of $80,000, your net business income after subtracting your SEP contribution from the original $100,000 of gross business income. Does that make sense?

Let's say business in 2013 was good. Cash flow was no problem. In that case, you could contribute up to $51,000 as long as your gross business income is $255,000 or more.

If you have employees, they can contribute a straight 25 percent of their gross compensation. So, a $100,000 employee could contribute up to $25,000 to their plan.

Like 401k and other retirement plans, your contributions are tax deductible and they grow tax deferred until retirement. Distributions from a SEP are taxable and those made prior to age 59-and-a-half may also be subject to a 10 percent penalty.

Best Fit

Who does this strategy work for? Anyone with self-employment income from their business can start and contribute to a SEP. It's great if you have the cash flow to fund a $51,000 contribution, but what if you have less?

SEPs are great retirement plans for self-employed people and small business owners who wish to contribute more than $5,500 to their retirement plan. If you can only contribute $5,500 or less, it may be easier and simpler to contribute to an IRA.

SEPs work well for self-employed people and small business owners who fit one or more of the following. You are...

  • Self-employed with earnings greater than $27,500 (If your income is lower than that, you may be better off with a traditional, tax-deductible IRA if you qualify to deduct your contributions.)
  • Have cash to fund a SEP contribution
  • Ineligible to contribute to a tax-deductible IRA or Roth IRA
  • Looking for a tax deduction you can do right now, for last year's tax return
A SEP contribution could shave thousands of dollars off your 2013 tax bill, but only if you take action now. SEPs must be funded before you reach your tax filing deadline, plus any extensions.
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