A SEP IRA can be a great retirement plan option for the self-employed and small business owners. It allows employers to put money away for retirement in an account that individual employees can fully control.
SEP stands for Simplified Employee Pension. The account can be an extremely useful savings and tax planning vehicle for a small business owner. As the business gets larger, however, SEPs have some pitfalls to watch out for.
How a SEP IRA works
At its core, a SEP IRA is a traditional IRA. Instead of an individual making contributions directly, however, their employer contributes funds into the account. Once the funds are in the account, the employee manages the account, and it follows the same investment, distribution, and rollover rules as a traditional IRA.
Opening a SEP IRA is, as the name implies, very simple. Most banks and brokerages offer a preapproved prototype plan that meets the IRS standards. The IRS also offers business owners the option of using its own model SEP or a custom plan. Employers must provide all pertinent information about the SEP to employees. Then the business owner can open individual accounts for each participant.
The deadline for opening a SEP IRA is the due date of the business’s income tax return. SEP IRA contributions are deductible as a business expense on corporate tax returns. People who are self-employed and don’t file a corporate tax return can deduct contributions on their individual tax return.
Individuals will pay taxes on their withdrawals, just as with a traditional IRA. There’s also a 10% penalty for withdrawals before you're 59 1/2 years old, and required minimum distributions starting at 72 years old.
The investment options in a SEP IRA account will depend on where the account is held. Most brokerages will allow account holders to buy and sell most securities and financial instruments the account holder wants, including stocks, bonds, ETFs, mutual funds, money market funds, and CDs. The IRS prohibits derivative trades with undefined or unlimited risk in qualified plans like a SEP IRA, but a broker may impose additional restrictions on options trading as well.
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SEP IRA eligibility
You are eligible to establish a SEP IRA if you’re self-employed or a small business owner.
Eligibility for each employee is determined by the plan details. The IRS stipulates that an employee must be included in the plan if:
- They’re at least 21 years old.
- They have worked for the company in three of the last five years.
- They received at least $600 in compensation for 2020, or $650 in 2021.
An employer may set less strict requirements, but eligibility provisions must apply equally to all owners and employees. Those restrictions can be changed in the future, but must meet the minimum standards set by the IRS.
The ideal candidate for opening a SEP IRA is a small business owner with few employees, none of whom meet the eligibility requirement. It’s also a good option for owners with a few eligible employees and low compensation, and for highly compensated owners of single-person businesses.
This is because a SEP IRA is simpler and less expensive to set up and manage than a small-business 401(k) plan or other employer-sponsored retirement plan. But if a self-employed person has no employees, a solo 401(k) may be a better option for saving for retirement and tax planning. Many brokerages offer free solo 401(k) plans.
If a person makes enough money to max out a SEP IRA contribution limit from self-employment, they may choose it over an individual 401(k) plan. A SEP IRA, unlike a 401(k), doesn’t require the administrator to file form 5500 when assets surpass $250,000.
SEP IRA contribution limits
The contribution limit for a SEP IRA is the smaller of:
- 25% of compensation, or
- $57,000 for 2020 or $58,000 in 2021.
That’s a heck of a lot more than the $6,000 contribution limit for a traditional IRA, or $7,000 if you’re 50 or older.
The employer decides what percentage of compensation to contribute, and can change that election from year to year. It can even decline to fund the SEP plan for the year.
Compensation for salaried employees is straightforward. Whatever appears on an employee's W-2 Box 1 is their compensation. For sole proprietors, compensation is the net earnings from the business.
Importantly, contributions must be equal as a percentage of compensation for all participants. If an employer contributes 25% of their own compensation to the SEP, they must contribute 25% of each employee’s compensation to those respective accounts as well. That’s another reason SEPs are best for business owners with very few eligible employees.
If an employer contributes to a SEP IRA plan, it doesn’t prevent employees from opening their own separate traditional or Roth IRAs. However, participation in an employer-sponsored retirement plan may limit how much of their traditional IRA contribution is deductible. It may also limit their ability to contribute directly to a Roth IRA.
It’s also worth noting that participation in a SEP IRA may interfere with the backdoor Roth IRA. An individual 401(k) account will not affect the backdoor Roth IRA.