What is a SEP IRA?
A Simplified Employee Pension Plan (SEP) is an Individual Retirement Account (IRA) established by an employer or a self-employed person. An employer can make optional payments to each qualified employee’s plan; tax deductions are available to the employer for any contributions made.
SEP IRA was designed especially for self-employed individuals and small company owners who want to save money for retirement alongside their employees without dealing with complicated plan administration. This retirement plan is essentially a conventional IRA with the flexibility to receive employer contributions.
The contributions in the SEP IRA are immediately vested. "Vesting" in retirement plans refers to ownership. This means that every employee gets or owns a certain percentage of accounts in the plan every year. Employees who are 100% attributable to their account balance have 100% ownership and cannot be withdrawn by the employer for any reason.
In regular 401k plans, the employer can install a vesting schedule, by which ownership of the contributions is only gained after you work for the company for a specific length of time. Like regular IRAs, SEP IRAs are entirely owned and run by the account's beneficiary, and the funds in a SEP IRA are not taxed until withdrawal.
Generally speaking, a SEP IRA may be suitable for you if you are self-employed, have few workers, or have a freelance income and desire flexibility in the amount you contribute yearly.
In addition, you might have heard about the 408(k) plan. Again, there are no differences between SEP IRA and this retirement plan. They are the same plan as the 408(k). It is simply the IRS Code number (IRC) for SEP IRAs.
How does a SEP IRA work?
A SEP IRA appeals to many business owners since it does not need many start-ups and operating fees like most traditional employer-sponsored retirement plans. Many businesses also set up a SEP IRA to allow their employees to make higher contributions than a regular IRA permits.
Small businesses choose SEP IRAs because of the eligibility criteria for contributions, including a minimum age of 21, three years of work, and a $600 compensation minimum. Furthermore, a SEP IRA enables employers to forego contributions during years when business is down.
SEP IRAs are taxed similarly to traditional IRAs and offer the same investment possibilities. These retirement plans are subject to the same transfer and rollover requirements as traditional IRAs. When an employer contributes to SEP IRA accounts, the amount provided is tax-deductible. Furthermore, the company is not obligated to make yearly payments; decisions regarding whether to contribute and how much to change year to year.
The employer is not in charge of investing decisions. Instead, the IRA trustee decides which investments are qualified, and individual employee account owners make investment selections. In addition, the trustee deposits payments provide annual statements and files with all needed papers with the IRS.
Contributions to SEP IRAs are also instantly fully vested, and the IRA owner controls the investments. A qualified employee (including the company owner) who participates in their employer's SEP plan must create a traditional IRA into which the employer will deposit SEP contributions.
SEP IRA Contribution Limits
Employer contributions cannot exceed the lesser of 25% of an employee's salary or $58,000 in 2021 (increased from $57,000 in 2020). Like ordinary retirements from the IRAs, withdrawals from the retired SEP IRAs are taxed by regular income tax.
As the SEP financing vehicle is a conventional IRA, after depositing SEP contributions, they now become standard IRA investment, which subjects them to many traditional IRA restrictions, including those listed below:
- Distribution rules
- Investment rules
- Contribution and deduction rules for conventional IRA contributions, which apply to the employee's normal IRA contributions, not the SEP employer contributions
- Documentations needed to establish an IRA requirement for establishing an IRA.
Each SEP-IRA must fulfil the documentation needed for a traditional IRA in addition to the documents necessary for creating a SEP plan.
SEP IRA Rules
SEP-IRAs require less administration. Nonetheless, you need to keep in mind that not all companies can establish SEP IRAs, which were originally intended to supply retirement benefits among enterprises that would not otherwise set up employer-sponsored plans.
Can an employee contribute to a SEP IRA? Employees can pay up to 25% of their annual salary. If you are self-employed (e.g., freelancers), you may contribute 20% after deducting the self-employment tax deduction of your business's net earnings or the employee share contributed.
You can contribute any amount you choose each year, up to the maximum SEP-IRA contribution of 25% of your pay (20% if you're self-employed) or $58,000 for the tax year 2021 (increased from $57,000 for the tax year 2020).
Furthermore, certain categories of employees may be barred from enrolling in a SEP IRA by their employer, even if they are otherwise eligible under the plan's regulations. Workers covered by a union collective bargaining agreement, for example, may be excluded. Non-resident alien workers may also be excluded if they do not receive U.S. income or other service payments from their employer.
Who is eligible for a SEP IRA?
If you are a business owner or self-employed, you are qualified to open a SEP IRA. If you have employees, the IRS considers them "qualified" for a SEP IRA if they fulfil the following criteria:
- Individuals from the age of 21 or older
- Worked for the company in 3 of the past five years
- Individuals who are paid $650 or more in compensation in 2021
SEP IRAs must be established for all qualified employees, not just one employee. While an employer may establish less strict qualifying standards, the same rules must apply equally to all firm owners and workers. A company's qualifying requirements can be changed anytime, as long as they are at least as strict as the IRS standards.
Advantages and disadvantages of a SEP IRA
Here are some advantages and potential disadvantages of a SEP IRA:
Advantages of a SEP IRA
You might wish to explore a SEP IRA since they are simple to set up and manage. In addition, administrative costs are modest, and, except for sole proprietors, you don't have to do much IRS reporting (if any).
There is also plenty of freedom as to how much you can contribute and when. For example, there is no requirement to pay the same amount of contribution each year. If your company seems to have a bad year, you might contribute less.
It is also possible to opt out of contributing for one year. Because of this flexibility, you can contribute more when you have money and less when not.
Contributions to a SEP IRA are also tax-deductible if you are a sole proprietor or an employer. As a result, you can lower your taxable income while contributing to your workers' retirement funds. Investments increase tax-free as well. However, employees cannot claim a tax deduction on their returns since they do not make contributions.
SEP IRAs are especially popular among sole proprietors since they allow for higher contribution limits than other types of IRAs. In addition, the time and money required to establish and maintain a plan are also reasonable.
Another significant benefit is that you can make employee contributions until the company's tax filing deadline. If, for example, your company's tax return is due in March and you file a six-month tax extension, bringing your tax return due in September, you have until the September tax deadline to pay employee contributions. The same deadline applies to establishing a SEP IRA for the prior tax year.
Potential Disadvantages of a SEP IRA
The main disadvantage of a SEP IRA is that if you set one up and contribute as an employer, you must contribute a fair percentage for all of your eligible employees. Keep in mind that all contributions to your workers' SEP IRAs are made by you, their employer. That might not appear to be a major problem if you just have a few people to work with you, but it gets harder as the team size expands.
Because the company makes all contributions, individual employees cannot contribute more if they desire to save more for their retirement. They will instead need to create an IRA or another form of savings account.
How to set up a SEP IRA?
It is easy to set up a SEP IRA. Most banks and brokerage firms provide a pre-approved SEP IRA plan template that fulfils IRS requirements. The IRS also provides business owners with the choice of utilising either its own model SEP or a customised plan.
Employers must give employees all essential information regarding the SEP IRA. Then, the business owner can then create separate accounts for each qualifying individual.
The IRS recommends three steps for establishing a SEP IRA:
- First, a formal written agreement should be created. You can accomplish this using IRS Form 5305-SEP or by contacting your account provider.
- Inform qualified employees about the SEP IRA. You can provide them with a copy of IRS Form 5305-SEP or equivalent information obtained from your account provider.
- Set up an individual IRA with the account provider for each eligible employee.
How do I invest my SEP IRA?
After the account has been created, you'll be able to pick among the investments offered by your account provider. Typically, equities, bonds, and mutual funds are included in the decision. You can create an IRA at a bank, but you'll be confined to investing in Certificates of Deposit, which typically provide a lesser return than a diversified portfolio of stocks and bonds.
After you've opened and financed the account, you'll want to invest it based on your age, projected retirement age, and risk tolerance. If you have a relatively good tolerance for market fluctuations and a long time before retirement, you should lean toward stocks, especially stock index funds, which follow a sector of the market and hold a diversified mix of firms within that section.
The less time you have before retirement — and the less patience you have for a market collapse — the more money you should put into bonds and bond funds. Bond index funds are also available.
Withdrawing from a SEP IRA
Contributions and profits from SEPs are stored in SEP IRAs and can be withdrawn at any time, subject to the usual restrictions placed on regular IRAs. A withdrawal is taxed in the year it is received. If a member does a withdrawal before age 59, an extra 10% tax is typically levied. As a result, after the age of 59, you can begin taking penalty-free withdrawals from your account.
There are few exceptions, such as a rollover to another IRA, some higher education costs, eligible first-time home purchase expenses, death, disability, and some medical expenses. In these few cases, you can avoid a 10 percent penalty for taking this money before age 59.5.
The regulations for SEP-IRA rollovers and transfers are the same as for regular IRA plans. This means you can transfer assets to any eligible retirement plan, such as a 401(k) investment options with SEP IRAs.
The kinds of securities that SEP IRA owners can hold in their accounts are generally unrestricted. The Internal Revenue Service (IRS) prohibits collectibles or life insurance, although these asset classes are unlikely to appeal to most investors. The IRS also prohibits investors from utilising SEP IRA money to trade derivatives with undefined or limitless risk.
The exact investment possibilities accessible to each SEP IRA holder vary based on the location of the account. Most brokerages allow SEP IRA owners to purchase and sell most assets and financial instruments, including stocks, ETFs, bonds, money market funds, mutual funds, and certificates of deposit (CDs). While certain forms of trading activity, such as options trading, are prohibited by several brokerages.
Combining a SEP IRA with other retirement plans
You can still open other types of retirement accounts if you have a SEP IRA. However, because a SEP IRA is an employer-sponsored retirement plan, the IRS puts certain extra constraints on your ability to contribute to other pension accounts.
SEP IRAs combined with traditional IRAs
You can start a traditional IRA even if you have a SEP IRA. However, if your employer contributes to your SEP IRA and you make more than a particular amount of money, your traditional IRA contributions are not entirely tax-deductible. The tax benefit begins to phase away in 2021 when your modified adjusted gross income exceeds $104,000 for married couples filing jointly and $65,000 for individuals.
SEP IRAs combined with Roth IRAs
Even if you have a SEP IRA, you can set up a Roth IRA. The maximum amount you may contribute to a Roth IRA each year is not affected by owning any employer-sponsored plan, such as a SEP IRA.
SEP IRAs combined with 401(k)s
Since both types of accounts have their annual contributions limitations combined, it is not probable that you have a SEP IRA and a 401(k) from the same business. However, you can completely enrol in both employer-sponsored retirement plans if you have two different jobs that offer two retirement plans. For example, you may have a SEP IRA at one job and a 401(k) at another one.
SEP IRAs combined with HSAs
You can contribute to a SEP IRA as well as a Health Savings Account (HSA). Contributions to SEP IRAs have no effect on HSA contribution limitations or the tax treatment of HSA contributions.
If your employer provides both a SEP IRA and an HSA and contributes matching money to the HSA, the HSA funds are charged to you as an employee. This additional "income" raises the maximum amount of money your employer can contribute to your SEP IRA, which is still limited to 25% of your salary.
SEP IRA VS Other retirement plans
SEP IRA vs. Individual 401(k)
A SEP IRA and an individual 401(k) are both retirement plans that accept contributions from employers. However, these two retirement plans have two main differences.
First, while the maximum contribution limit for both is comparable once income levels reach $200,000, you can contribute more to a 401(k) at lower income levels than a SEP IRA. Furthermore, if you are 50 or older, the 401(k) allows you to make a catch-up contribution, but the SEP IRA does not.
The second significant difference is that you may take a loan against your 401(k), something you cannot do with a SEP IRA.
A SEP IRA, on the other hand, is simpler to set up and maintain. Individual 401(k)s need more involvement from the owner in administrative responsibilities, and they can also produce more costs than SEP IRAs.
SEP IRA vs. Traditional IRA vs. Roth IRA
There are significant distinctions between these three types of retirement funds. First, you contribute tax-free money to a conventional IRA, which decreases your tax bill in the year you make the contribution. When you withdraw your money in retirement, however, they are taxed as regular income, and you must begin taking distributions once you reach the age of 72. This makes it ideal for those who anticipate retiring in a lower tax bracket.
The procedure is reversed with a Roth IRA. Because you have previously paid income tax on your contributions, withdrawals in retirement are tax-free. As a result, a Roth IRA is preferable for those who expect to be in a higher tax rate in retirement. Furthermore, there are no required minimum withdrawals from a Roth IRA, so you may leave the money alone and pass the account on to your heirs if you don't need it.
A SEP IRA is only offered to self-employed individuals. It accepts employer contributions, which conventional and Roth IRAs do not, and all contributions are tax-deductible, which means that withdrawals in retirement are taxed as regular income.
The maximum contribution limit for a SEP IRA is significantly greater than the maximum contribution limit for a conventional or Roth IRA. Employers can claim a tax deduction for their contribution, implying that a self-employed person can claim that tax deduction if they are both an employer and an employee. SEP IRAs were developed to assist small businesses in offering employer-sponsored retirement plans to their employees and owners.
Is a SEP IRA right for you?
SEP IRA contributions are deductible as a business cost on corporate tax returns, while SEP IRA contributions are tax-deductible on individual tax returns for self-employed people. These tax advantages, low costs, and the ease of setting up a SEP IRA, make them desirable to many businesses.
However, because business owners are responsible for 100% of SEP IRA contributions and must pay equally on a relative basis to the SEP IRA of each owner and employee, SEP IRAs are not suitable for every firm. SEP IRAs are best suited for small firms with few employees and few or no employees who fulfil the qualifying requirements. Because of the high contribution limits, highly compensated owners of single-person firms can also profit from SEP IRAs.
A SEP IRA may be a wise choice if you earn enough money to contribute the maximum allowable amount to one. However, if you are self-employed and do not have any employees, a solo 401(k) may be a better option.
If you want to discuss further before deciding to invest in a SEP IRA, contact a Cameron James Financial Adviser now!