One question we receive a few times a year is whether a W-2 employee who is already covered by a retirement plan through their employer at work (for example, a 401k) can make a SEP-IRA contribution based on self-employment (SE) Income they earn from a business they own.

The short answer is yes. But, there are rules that may limit the amount of contribution and, in addition, establishing the SEP can have unforeseen tax implications that should be considered before setting up the plan.

For purposes of this discussion we will assume plan rules/limits for calendar year 2016 and will not be discussing catch-up contributions.  Let’s start by outlining the basics of each type of account.

401k’s are established by an employer and allow W-2 employees to make elective deferrals up to $18,000 from their paycheck to their retirement account. In addition, the employer may also make matching contributions to the employee’s retirement account. The maximum (employee + employer) contribution that can be made on behalf of an employee during the year is $53,000.

SEP-IRA’s are established by an employer and allow the employer to make contributions on behalf of the employees to a retirement plan.  A self-employed individual is considered an employee of his business for purposes of the SEP-IRA. The maximum contribution that can be made on behalf of a self-employed individual (who has no employees) during the year is the lesser of 25% of adjusted self-employment earnings or $53,000.

If you are both 1) a W-2 employee included in a 401k plan and 2) a self-employed individual with a SEP-IRA plan, you may be able to make full contributions to both plans OR your contributions may be limited, depending on the relationship, if any, between the two businesses.

Both Plans are through Businesses You Own/Control

If you are self-employed and have both a SEP-IRA and a solo 401k through your business (or related businesses) your contributions will be limited. Because both businesses are related, your maximum contribution combined across the plans is the lesser of 25% of compensation or 53k.

Both Plans are through your Employer

If you are an employee and have both a SEP-IRA and a 401k through your employer (or related employers) your contributions will be limited. Your elective deferral to the 401k is limited to 18k and the total amount that can be deferred between the two plans is 53k.

401k Plan through an Employer & SEP-IRA through Your Business – Employer and Business are Unrelated

If you are an employee with a 401k through your employer and you are also self-employed and have a SEP-IRA through your own business, your contributions will not be limited if the 401k employer and your self-employment business are not related. In this case, you may make a full 18k deferral to your 401k through your employer and a full $53k contribution through your SEP-IRA (subject to the limits based on 25% of your self-employment income).

However, SEPs can have drawbacks which is why you may not want to set one up and fund your contribution even though you are eligible. The biggest drawback to fully funding a SEP is if you have employees. If you have employees, you are required to also fund their SEP account. Once you’ve established a SEP account you will also have ongoing maintenance of that account – you can’t just shut it down once you’ve decided you don’t want to use it any more.

This blog post is for general information only. Retirement planning is an extremely tricky area of the tax law and you should always consult with professionals before establishing or making contributions to plans.