Saving for retirement is important, but it's also complicated. Investors trying to navigate the world of retirement plans have to deal with an alphabet soup of acronyms and references to Internal Revenue Code section numbers, while IRAs, 401(k) plans, 403(b) plans, and other types of retirement vehicles come in both traditional and Roth flavors. Finding the right solution to allow you to save as much as you can toward retirement without creating a mountain of paperwork and administrative headaches might seem almost impossible. But when it comes to combining simplicity with the ability to maximize your retirement savings -- and to make the most of available tax breaks -- the SEP IRA can give employers and employees alike the best of all worlds.
What is a SEP IRA?
SEP IRA stands for Simplified Employee Pension Individual Retirement Arrangement. SEP IRAs are established by employers on behalf of their employees, and they're a common way for self-employed individuals to maximize their retirement savings. Small businesses often take advantage of SEP IRAs as well in order to give employees the retirement-savings benefits they want.
Notwithstanding its employer-centered nature, the SEP IRA takes many of its principal features from ordinary IRAs, as its name suggests. Money that your employer contributes to a SEP IRA on your behalf isn't included in your taxable income. Moreover, if you're a sole proprietor of your own business, the contributions you make to your own SEP IRA are deductible from your taxable income. So long as your money remains within the SEP account, it grows on a tax-deferred basis, meaning that you don't have to include investment income or capital gains on your yearly tax returns. Instead, withdrawals from SEP IRAs during retirement are included in your taxable income at ordinary tax rates, which for many people will be far lower after they retire than when they are at the height of their careers.
One positive aspect of SEP IRAs is that they let participants invest in a wide variety of different types of investments. Unlike 401(k) plans, which almost always have limited menus of investments from which employees have to choose, a SEP IRA gives participants the flexibility to choose whatever a given financial institution offers.
The biggest benefit of the SEP IRA
But the most important reason why the SEP IRA is such a strong retirement-plan option is that it allows you set aside extremely high amounts of money for retirement. In 2014, an employer can contribute up to 25% of each employee's wages toward their respective SEP IRAs, up to a maximum of $52,000. For self-employed individuals, the 25% limit is applied after accounting for the impact of the tax deduction and associated self-employment taxes on earnings, leading to a slight reduction in the effective percentage. But even with these adjustments, people who work for themselves can put almost 20% of their net profits into a SEP IRA. For high-income earners, that can be a huge advantage over the smaller limits of alternatives such as regular IRAs and SIMPLE IRAs.
For business owners with employees, it's important to understand that SEP IRAs don't allow owners to discriminate among employees. Therefore, if you make a 25% SEP IRA contribution on behalf of yourself as owner, you also have to make a 25% contribution for your employees who qualify to participate in the plan. According to IRS rules, the most restrictive arrangement you can make in a SEP IRA is to require employees to have worked for you for at least three of the most recent five years in order to get contributions.
Keeping it simple
The other major advantage of SEP IRAs is that they're much simpler to set up than other employer-sponsored plans that provide anywhere near the savings potential. With outright 401(k) plan setups, up-front and annual administrative requirements complicate the management of your retirement plan, adding potential pitfalls that could jeopardize the entire purpose of the plan if you make mistakes.
By contrast, opening a SEP IRA is as simple as going to a broker and asking for typical plan paperwork. The IRS has a standardized form, Form 5305 (link opens PDF), that allows you to set up a basic SEP IRA. Most financial institutions are familiar with that form and will let you establish SEP IRA accounts with a minimum of hassle. Administrative costs are usually minimal, especially compared to those of more complex choices like 401(k) plans.
Whether you're a business owner, a self-employed worker, or an employee of a small business lobbying for retirement plan coverage, a SEP IRA is definitely worth a close look. With such huge potential for savings in such a simple format, a SEP IRA just might be the best retirement-plan solution you'll ever find.
How to get more income during retirement
Saving for retirement is important, but you also need to focus on boosting your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.