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SEP IRA: What It Is and Why You Should Open One

Posted by Admin Posted on Jan 03 2019

SEP IRA: What It Is and Why You Should Open One

As a self-employed individual, small business owner, or even as a contract worker, it’s easy to get caught up in the day-to-day operations of your business and not think about retirement. That’s where a SEP IRA comes in. SEP stands for Simplified Employee Pension, and IRA stands for Individual Retirement Account. 

A self-employed individual, a business owner with one or more employees, and a person with a freelance income can open a SEP IRA to invest in their retirement. Let’s cover a few frequently asked questions regarding SEP IRAs below.


Who benefits from a SEP IRA?

The name Simplified Employee Pension is just what it means: simplified. Specifically, this means a SEP IRA is a basic retirement account. It’s best suited for self-employed individuals due to the compensation rules. In sum, if you have eligible employees (more on eligibility below), any contribution you make to your own SEP IRA must also be made to your employees. For example, if you choose to contribute 10% of your net business income to your SEP IRA, you must also contribute 10% of all qualified employees’ wage income from your business to their SEP IRAs.


Are all employees eligible for a SEP IRA?

No, but most probably are. If you offer a SEP IRA, an employee who is 21 or older and has worked for you for at least 3 of the past 5 years and has earned $600 or more from you in 2018 is eligible. Each of these employees or contract workers, unless covered by a union contract, can participate in a SEP IRA. If offered, all eligible employees or contract workers must participate.


Is a SEP IRA difficult to set up?

A SEP IRA doesn’t have to be difficult to set up. According to the IRS website, 4 things are needed to make it happen:

     • A trustee for the plan (this could be a bank, credit union, mutual fund family, or an investment brokerage)

     • A written agreement to provide benefits to all eligible employees

     • A method to give employees information about the agreement

     • Setting up an IRA account for each employee


What are the caps on contributions?

You can contribute up to 25% of your net income (net income up to a maximum of $275,000 annually) to your SEP IRA. This means that up to $55,000 can go into this IRA account each year. (If you’re catching up older employees, you can contribute up to $61,000.) Doing the math, you’ll realize that the only difficult thing to navigate is the fact that 25% of $275,000 is $68,750, which is more than the contribution cap. The IRS allows you to walk around this by deducting the amount of the contribution before you calculate your income.


How effective is the SEP IRA for retirement savings?

If you max out your contributions each year, your plan could potentially reach $1,000,000 (based on an assumed rate of return of 7%) in only 12 years. This is the long-term benefit. The shorter-term benefit is that this contribution lowers your taxable income.  A SEP IRA contribution could save you thousands of dollars each year.  Think about this – if you fall in the 24% bracket a contribution of $10,000 could save you $2,400 on your federal return. 


How should I time my contributions?

You have until the due date of the tax return (including extensions) to make a SEP contribution.  This means that if you are a sole proprietor and extended your return from the standard April 15th deadline you could have up until October 15th to make a contribution for the prior year return. 

Overall, if you’re a self-employed individual, small business owner, or contract worker, the benefits of contributing to an SEP IRA are definitely worth considering.


Is there a downside to a SEP IRA?

The only thing to be aware of is that there are penalties for early withdrawal, as with any IRA. If you remove funds before you’re 59 ½, you’ll be subject to an additional 10% tax. When you reach 70 ½, required minimum distributions (RMDs) must be taken annually, as with any traditional IRA.


Does a SEP IRA complicate my tax filings?

Not at all! One of the best features of a SEP IRA is that contributions can be funded after the end of the year and before your tax deadline. In summary? Contributions are flexible throughout the year, so you can contribute in line with your particular cash flow. 

The IRS provides simple checklists and tips to ensure your SEP is operating within the proper bounds of the law. If for some reason you get off track, tax benefits could be lost. Fortunately, any errors can be corrected by using one of the IRS correction programs or by following their SEP Plan Fit-It Guide. If you’d like to understand more, let’s have that retirement planning conversation so you and any employees can benefit.