Personal Finance

The Ultimate Retirement Account for the Self-Employed

Bag full of money
Bag full of money


Self-employment definitely has an upside. You have a lot more control over your life when you work for yourself. The inevitable trade-off is that you lose the perks that many employees take for granted, like a steady paycheck, paid sick leave, and an employer-sponsored retirement account to help you someday leave the workplace forever. I can't help you out with the first two, but if you're self-employed, then you owe it to yourself to consider opening a SEP-IRA. These tax-advantaged retirement accounts have the benefits of a 401(k) and an IRA all wrapped up into one sweet package.

What is a SEP-IRA anyway?

A SEP-IRA, or simplified employee pension individual retirement arrangement, is designed as a simple way for small-business owners to fund their retirement savings (and those of their employees, if they have any). Businesses of any size can set up a SEP-IRA, but these plans are most valuable for self-employed individuals without any employees. You see, the big catch of a SEP-IRA is that if you make a contribution to any SEP account, including your own, you have to contribute an equally large percentage of income to the SEP accounts of all your eligible employees. This would certainly be a great perk for them, but it could quickly bankrupt a small-business owner with a lot of employees. But if you have no employees, there's nothing to worry about.

What makes SEP-IRAs so great?

Senior couple dancing on the beach


For starters, the maximum annual contribution for a SEP-IRA is the lesser of 25% of your compensation or $54,000 (in 2017). This blows the traditional IRA limit of $5,500 out of the water. A $5,500 annual contribution is a good start, but it won't exactly get you a villa on the Mediterranean to enjoy in your old age. The high contribution limits of a SEP-IRA allow you to tuck away almost 10 times as much money, which gets you a lot closer to that villa.

And just to put the cherry on top, contributions you make to a SEP-IRA are tax-deductible. This gives you an excellent opportunity to review your situation at the end of the year and use SEP-IRA contributions to minimize your tax bill.

SEP-IRAs are much easier to set up and maintain than 401(k) accounts. Most 401(k) accounts have relatively high setup and annual fees, and if your 401(k) account balance reaches $250,000 or more, you have to file a report every year with the IRS. SEP-IRAs generally have lower fees and no annual reporting requirements.

Finally, SEP-IRAs have extremely flexible funding requirements. You can contribute to a SEP-IRA at any time during the year or wait until the end of the year to decide how much you want to toss in there. That makes it easy to assess your business's financial situation and your own before you decide how much to contribute. If money is particularly tight, you can skip contributing altogether for the year.

SEP-IRA distributions work much like other tax-deferred retirement plans. You can't borrow money from a SEP-IRA, but if you desperately need the funds, you can take an early withdrawal and suck up the 10% tax penalty. You can roll over the funds at any time into another flavor of retirement account, assuming the new account permits rollovers. Penalty-free distributions can began at age 59-1/2, and required minimum distributions commence on April 1 of the year after the year in which you reach age 70-1/2.

I'm sold! Where do I sign up?

Virtually every bank and brokerage firm offers SEP-IRAs. First, you'll need to create a written agreement laying out the basic details of the plan. The IRS has a simple template that you can use for this purpose, Form 5305-SEP (which will need to be updated with the current date and contribution limits), or you may be able to get a template from the firm setting up your account. It's wise to shop around and compare fees before picking a SEP-IRA trustee to ensure that you get the best deal. Once it's established, a SEP-IRA will keep going indefinitely. If you later decide to shut down your SEP-IRA, simply notify the trustee and ask them to close the account. You don't need to notify the IRS, but it's a good idea to inform your employees (if any) that you've canceled their retirement accounts.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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