This article was updated on April 6, 2016. It was originally published on Sept. 29, 2015.
You may not be familiar with the SEP-IRA, but it could serve you very well as you save and invest for retirement -- especially if you're self-employed. If you are the owner of a business, it could help you and your employees save a lot of money, too.
What is a SEP account?
First off, know that the term SEP-IRA is short for Simplified Employee Pension IRA. Before delving into its details, let's review the two main kinds of IRAs, the traditional IRA and the Roth IRA. With the traditional IRA, you contribute pre-tax money that reduces your taxable income and, thereby, your tax bill for the year. When you withdraw the money in retirement, it's taxed as ordinary income to you; your tax hit was deferred. With the Roth IRA, you contribute post-tax money -- i.e., sums that don't offer any up-front tax break. But you do get a tax break -- and a potentially big one -- when you withdraw from the account in retirement -- because you get to take all the money out of the account tax-free.
The SEP-IRA rules are similar to those of the traditional IRA, but it has a few twists. While traditional and Roth IRAs are accounts most of us set up on our own, outside our workplaces, SEP-IRAs are tied to our jobs. A SEP is set up by an employer (including a self-employed person) and permits the employer (not the employee) to make contributions to the SEP-IRA accounts of eligible employees. The employer gets a tax deduction for contributions made, and the employee is not taxed on those contributions, though their eventual withdrawals will be taxed at their income tax rate. (Of course, a self-employed person is both employer and employee in this case, so he or she funds their own account.)
Deadlines and limits for a SEP plan
The SEP-IRA rules, like those governing traditional and Roth IRAs, include deadlines and contribution limits. The deadline for making contributions for a given tax year is the deadline for filing tax returns -- usually April 15. Also, as with traditional (but not Roth) IRAs, you must begin taking distributions from the account once you turn 70-1/2. You can start earlier, without penalties, beginning at age 59-1/2.
The SEP-IRA's contribution limits separate it from traditional and Roth IRAs -- in a big way. The more prevalent IRAs have a contribution limit of $5,500 for both 2016 and 2017, plus a $1,000 catch-up contribution for those aged 50 and older. The SEP-IRA, though, sports a contribution limit for the 2017 tax year that's the lesser of 25% of the employee's income or $54,000 ($53,000 for 2016). The limit is increased over time to keep up with inflation. As an example, if your income is $100,000, then your maximum contribution is $25,000 ($100,000 x 25%). Even for a roughly average income of $50,000, that's a hefty $12,500 per year.
The power of the SEP-IRA for retirement
Most people don't have the luxury of plopping $54,000 into their SEP-IRA each year, but if you manage to invest, say, $10,000 annually and earn an average of 8% per year, then in 20 years you'll end up with a substantial balance of more than $490,000. That can make a huge difference come retirement.
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 considered taxable income at the time and are taxed at income-tax rates, not long-term capital-gains rates.
A big advantage of the SEP-IRA over alternatives is that as with traditional and Roth IRA accounts that you set up at a good brokerage, you can invest your money in a very wide range of stocks and bonds, not to mention gobs of mutual funds and ETFs. That's not the case with, for example, 401(k)s, which typically feature limited investment menus. SEP-IRAs are also fairly simple to set up.
Here are a few more things to know about the SEP-IRA rules:
- 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.)
- Contributions are made on a pre-tax basis, lowering the employees' taxable income for the year of the contribution.
- The employee is always 100% vested in the accounts, meaning that the contributions made immediately belong 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: Employers can contribute in flush years and less in difficult years.
- Loans from SEP-IRAs are not permitted.
- Early withdrawals will face a 10% extra tax if the withdrawer is younger than 59-1/2.
- Beginning at age 70-1/2, required minimum distributions (RMDs) must be taken annually, as with traditional (but not Roth) IRAs.
If you're self-employed, or you lead a company without a retirement plan for employees, then you owe it to yourself to learn more about SEP-IRAs and to consider whether it's right for you or your employees.
To learn more about the different kinds of IRAs -- and which is best for you -- check out The Motley Fool's IRA Resource Center.
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