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The SEP IRA: Understand the Basics

Pat yourself on the back if you're familiar with the two key kinds of IRAs -- the Roth and the traditional IRA. They form the bedrock of many people's retirements. But for some folks, the SEP IRA is the best choice. Take a few minutes to learn more about it.

The simplified employee pension IRA is one that lets employers contribute to traditional IRAs for their workers, and it even works for self-employed folks who can contribute to their own SEP IRA. Why bother, you might ask, if they can just use regular, non-SEP IRAs? Well, because the Roth and traditional IRAs have annual contribution limits of $5,500 in 2013 and 2014 ($6,500 for those 50 or older). With an SEP IRA, the limit for 2014 is the lesser of 25% of the employee's pay or $52,000. If your income is $100,000, that's $25,000. Even for a more modest $60,000 income, it's a substantial $15,000.

The SEP IRA has some other benefits, too. With a 401(k) you can only invest your money in the plan's options, which are typically a range of mutual funds and perhaps a few other securities. But with many SEP IRAs, particularly those for self-employed folks, investments can be much broader, as in a Roth or traditional IRA. An SEP IRA set up with a good brokerage, for example, will work much like a regular brokerage account, giving you access to hundreds of mutual funds and thousands of stocks, bonds, ETFs, and perhaps even some CDs.

Here are some more details:

  • Only the employer (or self-employed person) contributes to the account, and there are generally no filing requirements for the employer. (Employees may also contribute to their own IRAs separately.)
  • The contribution is made on a pre-tax basis, so it lowers the employees' taxable income for the year of the contribution.
  • The value of the account will grow, tax-deferred, over time. Securities sold along the way won't trigger capital-gains taxes in their year of sale.
  • When withdrawals are ultimately made in retirement, they're taxed at income tax rates, not long-term capital-gains rates.
  • The employee is always 100% vested in the accounts, meaning that the contributions made belong immediately to him or her.
  • The employer's contribution rate must be the same for all eligible employees.
  • The SEP IRA's large contribution limit offers flexibility that's good for businesses with variable cash flow, so that more substantial sums can be contributed in good years and less in not-so-good years.
  • Loans from SEP IRAs are not permitted. (They are sometimes allowed from 401(k) accounts.)
  • Early withdrawals will face a 10% extra tax if the withdrawer is younger than 59 and a half.
  • Beginning at age 70 and a half, required minimum distributions must be taken annually, as with traditional (but not Roth) IRAs.

If you think you might be able to use an SEP IRA in your overall retirement plan, read up on it and give it some consideration. You can learn more about SEP IRAs from the IRS itself. 

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Once you have an SEP IRA, you'll want to use it to invest effectively. The best investment strategy is to buy shares in solid businesses and keep them for the long term. In the special free report "3 Stocks That Will Help You Retire Rich," The Motley Fool shares investment ideas and strategies that could help you build wealth for years to come. Click here to grab your free copy today.


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Selena Maranjian
TMFSelena

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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