Having a retirement plan at work can play a vital role in helping you set money aside for after you retire. The 401(k) plan has become extremely popular among large employers, and millions of taxpayers are able to get big tax breaks by using 401(k) plan contributions to their advantage.
However, not everyone has access to a 401(k). Especially among small businesses, the complexity and cost of setting up and maintaining a 401(k) plan can be too much to handle. However, there are some good alternatives that are tailored to smaller employers. One of them, the SEP IRA, offers extremely large contribution limits while also keeping things relatively easy to administer and manage.
Every year, the amount that one can contribute to a SEP IRA goes up with inflation, and recently, the IRS announced that SEP participants would be able to set aside $1,000 more during 2019 than they were able to save in 2018. With a simple yet effective approach, SEP IRAs deserve a closer look among companies that think they can't give their workers a retirement plan.
The basics of SEP IRAs
If you've ever done your own taxes, you know how complicated IRS regulations can be. In the retirement plan world, things get even more complex. To open a 401(k) plan, a business has to comply with many different regulatory requirements, and it has to be diligent in handling administrative tasks as they come up.
SEP IRAs were designed to make things easier on employers. The SEP part of SEP IRA stands for Simplified Employee Pension, and the primary idea is to keep things as simple as possible while still ensuring that people are using the tax benefits of an employer-sponsored retirement plan effectively.
In order to create a SEP IRA, the employer just needs to fill out a single form. That stands in stark contrast to the pages and pages of documents involved with a 401(k) plan, including plan adoption agreements and specific addenda to incorporate newer pension laws. After that, it's generally pretty easy for small businesses to get help with opening, administering, and managing SEP IRAs, because most financial institutions are familiar with them. They also provide investing flexibility that most 401(k)s don't.
Another $1,000 more for 2020 SEP IRA contributions
SEP IRAs come with extremely high contribution limits. You can establish a SEP IRA that lets you contribute up to 25% of your salary, with a maximum overall contribution limit of $57,000 in 2020. That's higher by $1,000 from 2019 levels, marking the latest in a string of similar increases over the past several years.
If you're self-employed, SEP IRAs are also available. The tricky part, though, is that the 25% limit is calculated on your net income, which means you first have to take out the employer portion of your payroll tax liability as well as the impact that the SEP IRA contribution itself has on your income. Typically, you'll find yourself able to contribute almost 20% of your original gross income.
Why aren't SEP IRAs more common?
One shortcoming of SEP IRAs is that they don't give employees the ability to make contributions on their own behalf. Instead, all the money that goes into SEP IRAs comes from the employer.
Because of that, SEP IRAs work best in situations involving family businesses and other close-knit groups of employees. In particular, self-employed individuals often turn to SEP IRAs, because often, those businesses have no other employees. However, there's a danger involved for self-employed people: If you later add an outside employee, you'll have to be consistent about putting the same percentage of salary toward the new employee's SEP IRA account as you do with your own. There are some limited exceptions until an employee has worked a certain minimum time period, but apart from that, you can't treat others unfairly.
Think about a SEP IRA
SEP IRAs can be great vehicles for retirement savings. Getting to save up to $57,000 without the hassle of a 401(k) gives many small businesses and self-employed workers exactly what they're looking for from a retirement account.