Businesses looking to take care of their employees often like to give lucrative fringe benefits, and an employer-sponsored retirement plan can be a great way that employers can show their workers that they care about employees' long-term financial prospects while also giving workers a way to save on their taxes. But setting up complex employee pension plans can be tough for a business. SEP IRAs give businesses a simplified option, with streamlined rules that make them less onerous to set up and administer than 401(k) plans and more complex choices. Let's take a closer look at SEP IRAs to see how they work and when they're most useful.
What is a SEP IRA?
A SEP IRA is shorthand for "simplified employee pension individual retirement arrangement." Employers are responsible for setting up SEP IRAs for their employees. In addition, self-employed individuals can set up SEP IRAs for themselves, playing the role of both employer and employee.
SEP IRAs resemble other types of traditional IRAs. Money that employers put into a SEP IRA aren't included in income, and money that employees contribute are deductible from your taxable income as well. Investments inside a SEP IRA are tax-deferred, meaning that you don't have to pay taxes on any income or gains that those investments generate until you make withdrawals from the SEP IRA.
Even though the SEP IRA is a simplified retirement savings option, it has some features that many 401(k) plans don't. Most important for investors is that SEP IRAs typically aren't subject to limitations on which investments you can make. Financial institutions typically offer nearly any investment you can think of within a SEP IRA, which is in stark contrast to the fixed menus of investments that most 401(k) retirement plans allow.
The pros and cons of SEP IRAs
The reason many business owners and self-employed workers find SEP IRAs appealing is that the limits on contributions are quite high. Employers can contribute up to a quarter of employees' wages, with maximum contributions of $53,000 for 2016 and $54,000 for 2017. That's much larger than alternatives such as SIMPLE IRAs and ordinary individual retirement accounts, and for high-income individuals, it makes it hard to match what SEP IRAs can allow.
In addition, it's easy to set up a SEP IRA. Most financial institutions make the paperwork easy, and the IRS offers a standardized form to establish a SEP IRA. Typically, using IRS Form 5305 is all you need to do to get started.
However, there's one thing to keep in mind with SEP IRAs: If you're a business owner and have employees, you can't make huge contributions to your own SEP IRA without making equal percentage contributions to employees' SEP IRA accounts as well. That isn't always bad if the salary disparities are large enough, and you can also require certain minimum work requirements to be eligible for the SEP IRA.
Even with that downside, SEP IRAs make it easy for employers to help their employees save for retirement. With far fewer requirements than alternative pension arrangements, a SEP IRA could be the best move for your business.
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