How A SEP IRA Works
A SEP IRA is a retirement savings plan designed for self-employed people and small business owners. Formally known as a Simplified Employee Pension, this plan lets entrepreneurs establish and contribute to individual retirement accounts for themselves and their employees. The SEP IRA works a lot like a traditional IRA, but there are additional rules and benefits you need to understand to decide if this retirement plan is right for your small business.
What Is a SEP IRA?
Don’t let the word pension fool you: SEP IRAs are defined contribution retirement plans. Think of SEP IRAs as part 401(k) plan and part traditional IRA, except employers make contributions to the plan. Like most retirement accounts, SEP IRAs provide tax-deferred growth of these contributions, but withdrawals are taxed as regular income when they’re made in retirement.
SEP IRAs differ from traditional IRAs in that they offer potentially much higher contribution limits. That’s because an employer’s total contribution limit is much higher than an individual’s traditional IRA contribution limits. Each year employers can contribute up to the lesser of $58,000 ($61,000 in 2022) or 25% of an employee’s income. Self-employed individuals or employers contributing to their own SEP IRAs can contribute slightly less, after accounting for tax requirements (more on this below).
For those who are self-employed, the fact that only employers can contribute may be largely symbolic: Ultimately, they’re investing for themselves, whether as “employees” or “employers.” Small business owners with employees besides themselves who choose a SEP must open accounts for all eligible employees and contribute the same percentage of compensation to each qualifying employee’s SEP IRA, including their own.
SEP IRAs give business owners lots of flexibility regarding when they make contributions. You can choose to make multiple contributions a year, or make one big contribution at the end of the year. You can even make contributions between the end of the year and your tax filing date.
Business owners also get tax deductions for their SEP IRA contributions. The most they can deduct from their business’s tax return is the lesser of their contributions or 25% of compensation.
Key Features of SEP IRAs
Employee Contributions and SEP IRAs
Some SEP IRA plans allow employees to make traditional IRA contributions to their SEP IRA account. This reduces the amount the employee may contribute to other IRAs. As an individual, in tax years 2021 and 2022 you are only allowed to contribute up to $6,000 ($7,000 if you are 50 or older) to all of your IRAs, including traditional, Roth and SEP IRAs. Any employer contributions do not affect how much you can contribute to an IRA.
Vesting and SEP IRAs
Employer contributions to an employee’s SEP IRA vest immediately, meaning that the employee has ownership of all assets in the account as soon as an employer makes a contribution.
That said, the rules of IRA withdrawals still apply. Workers generally can’t take the money early without paying penalties. If someone tries to withdraw money from a SEP IRA prior to age 59 ½, they’ll owe income taxes on the money as well as a 10% penalty, except under certain circumstances. They can, however, roll the funds into another IRA.
Loans and SEP IRAs
SEP IRAs, unlike 401(k) plans, aren’t permitted to make loans to participants. That said, it may be possible to make an early withdrawal from the account without paying a penalty in certain circumstances, including financial hardship, a first home purchase or higher education costs.
Who Can Open a SEP IRA?
Any sole proprietor, partnership, corporation or nonprofit organization can set up a SEP IRA, but it’s best suited to sole proprietors and small businesses with just a few employees. For a small business, a SEP IRA is a simple, low-cost way to offer retirement benefits to employees. For a self-employed person, the plan may allow you to save more for your retirement than a traditional IRA. To save even more, the self-employed may want to consider a Solo 401(k).
Which Employees Qualify for a SEP IRA?
If you set up a SEP IRA plan for your small business, you must include all of your employees who are 21 or older, have performed services for the business in at least three of the last five years and have received at least $650 in compensation from your business for the year.
This includes part-time employees, seasonal employees and any who left the business during the year. You can include workers in your plan who do not meet these requirements, but you don’t have to.
Some employees may be excluded from a SEP IRA, at an employer’s discretion, including:
• Employees who are covered by a collective bargaining agreement, if retirement benefits were part of the bargained plan.
• Nonresident alien employees who didn’t earn any income from you in the U.S.
• Employees who received less than $650 in compensation during the year or are younger than 21.
SEP IRA Contribution Limits
Contributions to an employee’s SEP IRA cannot exceed the lesser of either 25% of their compensation or $58,000 in 2021 ($61,000 in 2022). If you are self-employed and making SEP contributions for yourself, slightly different contribution limits apply.
All SEP contributions must be made in cash and are immediately vested in employee SEP accounts. If you have more than one defined contribution plan for employees, the limits apply to employer contributions made to all accounts.
Calculating Your Contribution as a Self-Employed Person
If you’re self-employed and making SEP IRA contributions on behalf of yourself, the same limits apply as for those with employees, but you’ll calculate the maximum deductible contribution differently. Your contribution max is calculated as net profit minus one-half of the self-employment tax and your SEP contribution. This will reduce the percentage of your pre-adjusted salary you can contribute.
When and How to Contribute to a SEP IRA
Employers and sole proprietors can contribute to a SEP IRA annually, but they don’t have to contribute to a SEP IRA every year. When revenues are down, they can choose to contribute less to the SEP IRA or not to contribute anything in that tax year at all. There is no additional paperwork required for changes in contribution levels.
But when employers do contribute, they must contribute equally for all participants, including themselves. This is true even if an employee died or left the company before they contributed to the plan as long as they performed work for the business during the year.
Contributions for a tax year must be made by that year’s federal tax filing deadline. If you file for an extension on your taxes, you must contribute before the end of your extension period.
What Are the SEP IRA Withdrawal Rules?
When you withdraw from your SEP IRA in retirement, you pay taxes on any withdrawals based on your current income tax bracket. Money can be used penalty-free for any purpose after age 59 ½, the federal retirement age.
Early SEP IRA Withdrawal Rules
Except under certain circumstances, if you withdraw money from a SEP IRA before age 59 ½, you’ll owe income tax on the entire amount withdrawn, as well as a 10% early withdrawal penalty, unless you qualify for an exception.
Exceptions to the SEP IRA Early Withdrawal Penalty
The 10% early withdrawal penalty can be avoided if the money is taken out for any of the following reasons:
• First-time home purchase (up to $10,000)
• Birth or adoption of a child (up to $5,000)
• Qualified higher education expenses
• Qualified medical expenses
• Health insurance premiums when unemployed
• Substantially equal payments
• Withdrawals by a beneficiary, after the account holder has died
Keep in mind that you (or your beneficiary) will still owe income tax on any withdrawals from your SEP IRA.
How Do I Open a SEP IRA?
Opening a SEP IRA requires that you put in place a written agreement to provide benefits to all eligible employees. The agreement must contain the name of the employer, what’s required for employee participation, the signature of a responsible official and a definite allocation formula. Many brokerages require you to have an Employer Identification Number (EIN) to open a SEP IRA.
You may be able to use the IRS’s model SEP plan document, Form 5305-SEP, unless one of the following situations applies:
• You maintain any other qualified plan, like a 401(k) or SIMPLE IRA
• You use the services of leased employees
• You want to use a non-calendar plan year
• You want to use an allocation formula that takes into account Social Security contributions you made for your employees
You may set up a SEP IRA with a bank, insurance company, mutual fund company or other financial institution that offers IRA accounts. You must apply to open the SEP, and each eligible employee must also submit an application.
A SEP can be established any time before a company’s annual tax filing deadline and can be used to make contributions for that tax year. For instance, if a sole proprietor’s tax deadline is April 15, 2022, to file taxes for tax year 2021, they may establish a SEP IRA anytime prior to that date and make 2021 contributions.
If there are eligible employees, employers must provide them with disclosures about the plan and allow them to enroll. This is true on a rolling basis: Once an employee becomes eligible, they must be informed. Each employee should receive a copy of the agreement containing participation rules and a description of how employer contributions may be made to the IRA, along with a copy of the completed Form 5305-SEP and a yearly statement showing any contributions to the plan.
Investment Options for SEP IRAs
Funds saved in a SEP IRA may be invested in any security, including mutual funds, exchange-traded funds (ETFs) and individual stocks and bonds. SEP IRAs generally offer more investment options than 401(k)s or 403(b)s, but the options available for any given SEP IRA depend entirely on the account provider.
The Bottom Line
The ability to save pre-tax money for retirement—and create a retirement benefits plan for your small business’s employees—is appealing to many sole proprietors and small business owners.
SEP IRAs allow self-employed people and small businesses with few employees to save a lot for retirement easily. However, their general inability to allow employee contributions and the requirement that business owners contribute the same percentage for all eligible employees, including themselves, may make SEP IRAs less appealing than SIMPLE IRAs.
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