SEP IRA: If You Are Self-Employed, This Is a Must-Have Retirement Plan

A SEP IRA provides a welcome choice for many business owners because the paperwork requirements are minimal and the amount you contribute is flexible.

However, a SEP IRA also allows you to maximize your contribution and put more money to work.

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What is a SEP IRA?

A SEP IRA stands for simplified employee pension individual retirement account.

This special type of IRA provides a simple way for self-employed individuals to make tax-deductible contributions toward retirement and allows larger contributions than other types of IRAs.

How to set up a SEP IRA?

Starting a SEP IRA is much simpler than other options like 401k plans, which is one of the plan’s main advantages. Follow these steps to get started:

  1. Make an agreement: The IRS provides Form 5305-SEP which you can use as the agreement for your SEP IRA. You don’t need to file this form with the IRS. Alternatively, your broker or IRA sponsor may also have a document you can use to execute your SEP IRA agreement. Form 5305-SEP uses outdated contribution limits but can still execute your agreement.
  2. Inform your employees: IRS rules require you to inform all eligible employees that you’ve adopted a SEP IRA. If you used Form 5305-SEP, give each employee a copy of the model plan. This step establishes the plan as adopted.
  3. Set up IRA accounts for your employees: Choose your plan sponsor and set up a traditional IRA for each employee. In most cases, you’ll choose a broker or mutual fund provider but banks and other institutions may also be options. Employees cannot contribute to their own account, however. Also, be aware that SEP IRAs don’t support Roth accounts.

You can set up a SEP IRA at any time before your tax deadline, even if you’ve filed for an extension. This can give you a way to shelter some income if your business has a banner year.

How does a SEP IRA work?

A SEP IRA works much like a traditional IRA but with a few key differences. A traditional IRA limits contributions to $6,000 per year in most cases, whereas a SEP IRA raises this limit considerably.

Another key difference is that a SEP IRA isn’t subject to phase-outs based on income. You can contribute even if you had a great year.

Contributions to a SEP IRA are tax deductible in the year you contribute, so a SEP IRA can reduce your tax burden now while letting you save aggressively for retirement.

Much like a traditional IRA, you pay taxes when you withdraw from your account.

However, because you can contribute a larger amount, the advantages of tax deferral may be more significant with a SEP IRA.

A SEP IRA can be a great way to save, although it’s often a better fit for the self-employed or those who have few employees.

If you contribute for yourself, IRS rules also require you to contribute proportionally for all eligible employees.

IRS rules govern which employees are eligible and small businesses may find that contributions for employees can add up quickly.

Advantages
of a SEP IRA
Disadvantages
of a SEP IRA
● Tax-deferred savings● Must cover all employees
● Reduced paperwork● All employees must receive the same percentage
● Flexible contributions● No loan provision
● Open a SEP IRA anytime● Penalties for early distributions
● Large contribution limits● Required distributions
● Roth and traditional IRAs not affected● 100% vesting for employees

Advantages of a SEP IRA plan

A SEP IRA offers several advantages compared to alternatives, such as a traditional IRA or solo 401k.

  • Tax-deferred savings: Much like a traditional IRA, a SEP IRA offers tax deferred savings. You don’t pay taxes until you withdraw from your account.
  • Flexible contributions: Make contributions at your discretion. In lean years, you can conserve cash. When profits are strong, a SEP IRA offers a way to reduce your tax burden while also saving for retirement.
  • Open a SEP IRA anytime: You can open a SEP IRA at any time prior to your tax deadline. This makes your SEP IRA a powerful tool in your overall tax strategy.
  • Large contribution limits: Alternatives, like a traditional IRA or solo 401k, have lower contribution limits. A SEP IRA allows contributions of up to $56,000 in some cases.
  • Roth and traditional IRAs not affected: The contributions you make to SEP IRA don’t limit the amount you can contribute to a Roth IRA or a traditional IRA.

Disadvantages of a SEP IRA plan

A SEP IRA might not fit all businesses. If you have employees, contributions can become expensive.

  • Must cover all employees: Your plan must include all employees over age 21 who have earned more than $600 during the year and who have worked for you during 3 of the past 5 years.
  • All employees must receive the same percentage: If you contribute 25% of your compensation to your plan, you must also contribute the same percentage for your employees. The costs can add up quickly.
  • No loan provision: Unlike a 401k, a SEP IRA doesn’t support loans. Money you withdraw is a taxable distribution in most cases.
  • Penalties for early distributions: With a SEP IRA, a 10% penalty applies to money withdrawn before age 59 1/2, which is like a traditional IRA. However, a Roth IRA allows you to withdraw your contributions at any age.
  • Required distributions: IRS rules require you to withdraw at age 70 1/2. By contrast, Roth IRAs don’t require withdrawals until after your death.
  • 100% vesting for employees: After you contribute to an employee account, your employee owns 100% of the contribution. By contrast, 401k plans allow partial vesting.

What investments can you hold in a SEP IRA account

Many of the rules that apply to traditional IRAs also apply to a SEP IRA. Even the investment types the account can hold mirror those of a traditional IRA. That means you can invest in any of the following:

  • Stocks
  • Bonds
  • Mutual funds
  • ETFs
  • CDs

However, if you choose a self-directed SEP IRA, your investment options expand to include real estate, notes, tax liens, and more.

The power of a SEP IRA account

SEP IRAs offer tax-deferred savings, which allows your investment to grow for decades. Compounding combined with tax-free growth can perform wonders over time.

For example, here’s what your contributions might look like based on your annual contribution and an 8% annual return:

Annual
contribution
10 years
at 8%
20 years
at 8%
30 years
at 8%
$14,000$202,810$640,663$1,585,955
$28,000$405,623$1,281,333$3,171,925
$42,000$608,435$1,922,002$4,757,894
$56,000$811,246$2,562,666$6,343,850

By comparison, contributing to a traditional IRA for 30 years with the same average return gives you an account balance of about $680,000 because IRS rules cap IRA contributions at $6,000 per year.

Q&A about your SEP IRA:

Can an employee contribute to a SEP IRA?

Employees can’t contribute to a SEP IRA. Only employers can contribute to an employee’s SEP IRA account but contributions aren’t required.

Can I have SEP IRA and 401k?

You can have both a 401k and a SEP IRA and make contributions to both. However, contribution limits vary depending on who is contributing to each plan, you or your employer. You can also roll over a 401k to a SEP IRA if you want to consolidate.

Can you cash out a SEP IRA?

A SEP IRA follows the same withdrawal rules as a traditional IRA. If you withdraw prior to age 59 1/2, a penalty of 10% applies to the amount you withdraw. Additionally, there are no loan provisions for a SEP IRA.

Can an LLC set up a SEP IRA?

Yes, an LLC can start a SEP IRA for the business owner and employees. Both single-member and multi-member LLCs are eligible. However, contribution limits vary based on your LLC’s incorporation type.

Are SEP contributions reported on a W-2?

SEP contributions aren’t reported on your W-2, assuming the contributions are within allowable limits. Federal income taxes and FICA taxes don’t apply to contributions at the time you contribute. Federal and state taxes may apply when you withdraw from your SEP IRA account.

Can self-employed people contribute to SEP IRA and a traditional IRA?

Yes, self-employed individuals can contribute to a SEP IRA. If you’re self-employed, contributions made to your account are tax deductible. This lowers your taxable self-employed income and may reduce the amount of income taxes you owe.

Can I use my SEP IRA to buy a house?

If you haven’t owned a home in the past 2 years, you can withdraw up to $10,000 from your SEP IRA to buy a house. If you need to withdraw more or you don’t qualify for the home buyer exemption, a 10% penalty may apply to the amount withdrawn. After age 59 1/2, you can withdraw without a penalty.

Do SEP plans have to file Form 5500?

If the only retirement plan your business offers to employees is a SEP IRA, you are not required to file Form 5500. If your business offers other retirement savings plans, like a 401k, Form 5500 is required.

Can an S Corp have a SEP IRA?

Yes, an S Corp can have a SEP IRA. However, the S Corp makes the contribution, so the tax deduction goes to the S Corp. Contributions made by the S Corp are not taxable to you or your employees and are not part of W-2 earnings, assuming the contributions don’t exceed IRS limits.

Summary

If you’re self-employed or you own a small business, a SEP IRA deserves a closer look.

Contribution limits are higher than with other types of retirement plans.

IRS rules also provide more freedom to high-income earners than with a traditional IRA because you can deduct a larger amount.

Flexible starting dates and discretionary contributions make a SEP IRA a compelling choice, although a SEP IRA is often a better fit for businesses that have no employees.

Freelancers and contractors can also benefit because a SEP IRA is available to anyone who has self-employment income.

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