401(k) plans are popular among major employers that want to help their employees save for retirement, but not every employer has the resources to create a full-blown 401(k) plan. SEP IRAs are a great alternative that smaller businesses and self-employed individuals can use as a retirement plan. Contribution limits for SEP IRAs rise with inflation, and a $1,000 boost to the maximum contribution for 2018 will make them even more valuable for some workers. The combination of simplicity and savings that SEP IRAs offer makes them an option that many employers that currently don't offer retirement plans should look into more closely.
How SEP IRA limits will change in 2018
Contribution limits for SEP IRAs are quite high compared to some other retirement plans. Employers are allowed to contribute up to 25% of the salary that they pay each employee, with an annual maximum limit that applies to high-income workers. For 2018, the maximum contribution allowed is $55,000, up from 2017's $54,000. That will mark the second straight year that SEP IRA limits have risen after a break in 2016 due to low inflation levels.
For salaried workers, calculating 25% of compensation is trivial, but the calculation is more complicated for self-employed entrepreneurs. The limit is calculated based on net self-employment income, which takes gross income but then removes both the SEP IRA contribution itself and the portion of self-employment tax that's allocable to the employer's payroll tax liability. After running the numbers, the limit is 20% of adjusted profit after taking out self-employment tax, or slightly less than 20% of your original gross income.
Image source: Getty Images.
What you should know about SEP IRAs
Small businesses can't afford to waste time with complicated retirement plans, and that's a big part of why SEP IRAs can appeal to them. The name SEP IRA is an acronym for Simplified Employee Pension Individual Retirement Arrangement, and the rules that govern SEP IRAs make them simple to establish and maintain. They typically lack many of the ongoing administrative and legal responsibilities that 401(k) plans and similar arrangements require. For example, it takes just one IRS form to set up a SEP IRA, compared to long and complicated plan adoption agreements for 401(k)s as well as regular reporting requirements that can be long and burdensome.
Also, most financial institutions will open SEP IRA accounts with only a minimum of hassle and paperwork. SEP IRAs typically let workers invest in a wide variety of different choices, avoiding the typical limited menu of investments that 401(k) plans impose. Often, you can choose any investment that you could make in a regular IRA, including the vast majority of investments that most people would want in a retirement account.
The downsides of SEP IRAs
SEP IRAs are different from 401(k)s and many other plans, however, in that employees don't make contributions of their own. It's up to the employer alone to set up and put money in SEP IRAs. That limits the ability of average workers to use SEP IRAs to their fullest, and it's typically only small-business owners and self-employed workers who take advantage of maximum contribution limits to SEP IRAs.
In addition, small-business owners with employees can't just use a SEP IRA for their own benefit. The percentage of salary that you contribute on behalf of employees must be consistent across the board, with only limited abilities to exclude workers based on length of service.
Take a look at SEP IRAs
Even with these shortcomings, the advantages of SEP IRAs are valuable enough to make them worth a closer look from self-employed workers and small businesses. With the chance to set aside as much as $55,000 in a tax-favored manner in 2018, SEP IRAs could be the right choice for you.
