You probably know about traditional IRAs and Roth IRAs, but there's a good chance you've never heard of the SEP IRA -- or considered whether you need to use it.
Meet the SEP IRA
To understand the SEP IRA -- less commonly known as the Simplified Employee Pension -- let's review the two most common types of IRA: the traditional and the Roth. The traditional IRA lets you deduct your contributions from your taxable income, lowering your tax bill that year. The money can then grow in the IRA account until withdrawn, when it's taxed at your income tax rate at the time of withdrawal. The Roth IRA has you contribute post-tax money, but when you withdraw funds from your account in retirement, it's all tax-free.
The SEP IRA works much like the traditional IRA, but with a few key differences. While traditional and Roth IRAs are accounts most of us set up on our own, SEP IRAs are tied to our jobs. An SEP is set up by an employer or self-employed person, and it permits the employer to make contributions to the SEP IRA accounts of eligible employees. The employer gets a tax deduction for contributions made, and employees are not taxed on them when they're made. However, employees' ultimate withdrawals will be taxed at their income tax rate.
So what's the big deal about the SEP IRA? Well, consider that traditional and Roth IRAs sport annual contribution limits of just $5,500 (plus $1,000 for those aged 50 and older). That's pretty good, and it can help you accumulate a lot of money over a long period. For example, $5,500 socked away annually for 25 years in an account that grows by the stock market's long-term average annual rate of about 10% will turn into $595,000. But if you've started late and have only 15 years until you retire, you'll accumulate just $192,000. Bigger limits, such as those offered by 401(k)s (currently $17,500 plus $5,500 for those 50 and up), can clearly make a huge difference.
Enter the SEP IRA, which sports a fat contribution limit of up to 25% of an employee's income, with contributions capped at $52,000 for 2014. Note that each eligible employee must receive the same percentage of compensation. If you have a SEP IRA and it receives annual contributions of $20,000 for 15 years, growing at 10% per year, you'll end up with more than $600,000 in tax-deferred savings, thanks to the SEP IRA.
Nuts and bolts
If you think the SEP IRA could be beneficial for your self-employed self or for your workplace, here are a few other things to know.
For starters, the deadline for contributions in tax year 2014, as with traditional and Roth IRAs, is April 15 of 2015. And as with a traditional IRA, you cannot withdraw funds without penalties until age 59-1/2, and you must begin taking distributions from the account by age 70-1/2.
Another advantage of the SEP IRA is that if you set up at a good brokerage, you can invest your money in a wide range of stocks and bonds, not to mention gobs of mutual funds and ETFs. That's not the case with employer-provided 401(k)s, which typically feature limited investment menus. SEP IRAs are also fairly simple to set up.
If you're self-employed or own a business without a retirement plan for employees, you owe it to yourself to learn more about SEP IRAs and to consider whether they may be right for you or your employees.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.