Promises of free money usually come with a caveat – something free now, so the seller can make more later. These promises play perfectly into our inclination to make decisions that come with a more immediate reward, rather than those that benefit our future selves.
We will present an opportunity for free money here, and it also comes with a caveat, but it’s just the opposite - you give something now, for something free in the future. And to do this, we must resist the pull of immediate gratification that is rooted in our psychology.
Most self-employed with a SEP IRA make their contributions at or near the year-end deadline – they are busy running their business, may have insufficient cash flow, prioritize other spending, or simply do not know that it is allowed by the IRS. But, if they were to front-load the SEP contribution at the beginning of the year, the additional time in the market has historically translated to free money.
We looked at two investors, a Proactive Investor and a Reactive Investor, from January 2, 2002, through March 31, 2022, each making the maximum annual contribution, and each fully invested in the S&P 500. The only difference is the Proactive Investor made their full contribution at the beginning of the year and the Reactive Investor at the end. As of March 31, 2022, the Proactive Investor had an account balance of $3,775,268, and the Reactive Investor had an account balance of $3,464,937. By moving up each annual contribution by one-year, the Proactive Investor was rewarded with $249,331 in additional investment return. Here is a breakdown of total contributions and investment return as of March 31, 2022:
How do you calculate the maximum contribution?
The maximum SEP contribution is calculated differently depending on the legal structure of your business and if you are running payroll. If you are organized as an S Corp and running payroll, it is the lesser of 25% of W-2 wages or the IRS annual limit. If you are organized as a Sole Proprietorship or single-member LLC, it is the lesser of 20% of net income minus one-half of self-employment tax or the IRS annual limit. The IRS annual limit for 2022 is $61,000. Let’s go through a few examples:
Owner is running payroll at an annual salary of $100,000 and organized as an S Corp. Annual salary is used as earnings - 25% of salary is $25,000. The maximum contribution is the lesser of $25,000 or $61,000, so $25,000.
Owner is running payroll at an annual salary of $300,000 and organized as an S Corp. Annual salary is used as earnings - 25% of salary is $75,000. The maximum contribution is the lesser of $75,000 or $61,000, so $61,000.
Owner is not running payroll and is organized as a Sole Proprietorship or single-member LLC - the formula for earnings in this case is 20% of net income minus one-half of self-employment tax. Assuming net income of $100,000. Self-employment tax is 15.3% or $15,300. Earnings are $100,000 minus $7,650 or $92,350. 20% of earnings is $18,470. The lesser of $18,470 or $61,000, so $18,470.
As a business owner it is important to understand the general concept, but work with your Investment Advisor and your CPA or Tax Preparer to calculate your maximum contribution; we can also help to make sure your set up with the most tax efficient legal structure.
But we are advocating a contribution into your retirement account at the beginning of the year before you know what your exact earnings are – how is this done?
We need to forecast next year’s revenue and earnings, and based on the confidence level of the forecast, determine a beginning of year one-time and/or recurring monthly contribution that will fall within the forecast. Then, at the end of the year, we calculate the actual number and make an additional contribution, if needed. And, if it ends up being an excess contribution, we can correct it penalty free before the tax deadline.
What is the role of an Investment Advisor?
The role of an Investment Advisor is to increase the probability of a better retirement outcome, which includes more than just selecting investments. The full service of a good Investment Advisor should include planning, rebalancing, asset location, and behavioral coaching, in addition to appropriate investment selection. Vanguard estimates the added value of an Investment Advisor can be as much as 3% in net returns. IIM is a Registered Investment Advisor dedicated to facilitating better financial outcomes through strong client relationships that are grounded in empathy, academics, experience, and education.
Justin Wollman
Investment Advisor
Intent Investment Management
415-717-2661
Sources: Intent Investment Management, Standard & Poors, Internal Revenue Service, and Vanguard
Disclosures: Intent Investment Management (“IIM”) is a Registered Investment Advisor ("RIA"). IIM’s CRD number is 315111. Registration as an investment adviser does not imply a certain level of skill or training, and the content of this communication has not been approved or verified by the United States Securities and Exchange Commission or by any state securities authority. IIM renders individualized responses to persons in a particular state only after complying with the state's regulatory requirements, or pursuant to an applicable state exemption or exclusion. All investments carry risk, and no investment strategy can guarantee a profit or protect from loss of capital. Investment products offered are not FDIC insured, may lose value and are not bank guaranteed. Past performance is no guarantee of future results. Investment advisory fees are described in Part II of Intent Investment Management’s Form ADV.