- A SEP-IRA (Simplified Employee Pension Individual Retirement Account) is a way for sole proprietors, independent contractors and small businesses to build retirement savings.
- SEP-IRAs operate as traditional IRAs in terms of tax deferral and withdrawal rules. However, the contribution limits for a SEP-IRA are significantly higher.
- Self-employed individuals will also want to consider a Self-Employed 401(k) option when determining which retirement plan is best.
A recent survey from the Transamerica Center for Retirement Studies noted that 40% of surveyed individuals “expect to receive a portion of their retirement income from 401(k)-style plans or individual retirement accounts.” As a small business owner, sole proprietor or an independent contractor, one option that you have to do so is a SEP IRA. But, if you are going to build adequate retirement savings, you must understand SEP-IRA rules thoroughly.
In this article, we’ll outline everything you need to know about SEP-IRAs. We’ll touch on what these retirement savings vehicles are, and the rules associated with them. After reading this article, you’ll be fully prepared to open an account and make annual contributions if the SEP-IRA is right for you.
What Is a SEP-IRA?
According to the IRS, “a Simplified Employee Pension (SEP) plan provides business owners with a simplified method to contribute toward their employees’ retirement as well as their own retirement savings. Contributions are made to an Individual Retirement Account (IRA) set up for each plan participant.”
So, a SEP-IRA account is a retirement tool that provides tax breaks to small business owners (and their employees), sole proprietors, and those who earn self-employment income to save for retirement.
Why Have a SEP-IRA?
SEP accounts allow self-employed workers to create a retirement plan beyond the traditional IRA. SEP-IRAs may also be appealing to freelancers and those who complement their regular salary with side gigs.
SEP-IRAs provide the same luxury to small business owners, who may not be able to provide their employees with benefits like a 401(k) which are costlier and more cumbersome to administer. Business owners can use SEP contributions to help set their employees up for retirement. Just as IRAs are useful because they allow employees to reduce taxable income, SEP-IRA contributions are also tax-deductible from self-employment income.
Additionally, SEP-IRA earnings grow tax-deferred. Tax-deferred savings are a useful option to help grow retirement savings, because earnings grow inside the account without the reduction of taxes. The earnings don’t grow tax-free forever, however. Owners will need to pay taxes when they withdraw funds in accordance with IRA withdrawal rules.
Think a SEP plan is right for you? Make sure you understand the rules associated with them.
When determining whether a SEP plan is the right retirement account option for you, you should first understand the contribution limits.
A traditional IRA has a $6,000 contribution limit for 2019. If you’re older than 50, the limit is $7,000 because of the catch-up provision of an additional $1,000. The limits were $5,500 and $6,500, respectively, in 2018; however, the deadline for funding this type of IRA was on April 17, 2019.
SEP plans, on the other hand, have higher contribution limits and extended funding deadlines than “basic” IRAs. The 2019 SEP employer and employee contribution limits (combined) are up to 25% of compensation not exceeding $56,000. The limits were the same in 2018, except that they could not exceed $55,000. If you filed an extension for your 2018 return (i.e., beyond April 17, 2019), you may fund your SEP-IRA up to the deadline of your tax filing extension.
There are also some withdrawal rules that you’ll want to be aware of before opening your SEP. SEP withdrawal rules are very similar to regular IRA rules.
Although you can withdraw from your SEP-IRA at any time, beware the tax consequences of making withdrawals before age 59 1/2. Because your contributions are tax-deferred, you’ll pay income taxes when you take distributions. If you withdraw income before you’re 59 1/2 years old, your funds will be subject to an early withdrawal penalty of 10%. You could receive a waiver to withdraw the funds, however. Examples of when the IRS will forgive this penalty include:
- Death of the account holder
- Higher education expenses
- Up to $10,000 for first-time homebuyers
- An IRS tax levy
- Qualified unreimbursed medical expenses
- Health insurance premiums if you’re unemployed
- Situations where a military reservist is called to active duty
If you qualify for one of these exceptions, you can withdraw funds without having to worry about the 10% penalty. However, you’ll still need to pay taxes on your withdrawals.
Once you hit the age 70 1/2, you are required to take minimum distributions each month. If you do not start Required Minimum Distributions (RMDs) before the deadline, you will face a 50% penalty on the total amount of the distribution. You must also report any funds that you withdraw — no matter how old you are when you do so — on your tax return. The withdrawals are subject to your ordinary income tax rate.
Rollover or transfer rules for a SEP-IRA are the same as traditional IRA plans. That means you can rollover funds to any qualified retirement plan, such as a 401(k), without penalty.
SEP-IRA: Pros and Cons
Still curious about whether a SEP-IRA is worth it? Consider these pros and cons.
- Easy to administer
- Higher contribution limits than IRA
- Immediate deduction to taxable income for the year
- Tax-deferred earnings
- Can establish the IRA as late as tax filing deadline (typically April 15), including extensions
- SEP-IRAs are tax-deferred, operating only as a“Traditional IRA” only — there is no Roth version of a SEP-IRA
If employed at a company offering a 401(k) or similar retirement plan, be sure to max out employer-matched contributions first before considering a SEP-IRA for your side hustle earnings.
How Does a SEP Compare to Self-Employed 401(k)?
Another option that your financial institution may offer is a Self-Employed 401(k), also known as an Individual 401(k) or Solo 401(k). Let’s compare the self-employed versions of an IRA and a 401(k).
In a Self-Employed 401(k), the employer (who could be yourself) also makes contributions on behalf of eligible employees. The employee (who could also be yourself) can also contribute. However, the limits for doing so are the same as the SEP-IRA contribution limits.
The main advantage of a Self-Employed 401(k) is that it’s possible to have a Roth version of a Self-Employed 401(k). This means that you fund the employee’s contribution portion of the account with after-tax earnings, and as long as you follow 401(k) withdrawal rules, you’ll never have to pay taxes on your gains. SEP-IRAs, on the other hand, operate just like Traditional IRAs and employee contributions are only tax-deferred.
A tremendous benefit of a Roth IRA is the ability for retirement savings to grow tax-free and for you to withdraw them tax-free. Roths could be particularly attractive to those in low-income tax brackets now. If you expect to be in a higher tax bracket when you withdraw the funds, then it could make more sense to pay taxes on earnings now and avoid having to pay them at a higher tax rate when you withdraw them at retirement.
It’s also easier to withdraw Roth contributions (i.e., what you paid into your Roth with after-tax money) at any time. They aren’t subject to the same tax regulations and penalties as Traditional IRAs.
However, only the employee contributions are eligible for Roth status. Meaning, employer contributions are tax-deductible to the employer and tax-deferred only for the employee. There is no Roth equivalent for the employer contribution in a Self-Employed 401(k) plan.
A key drawback to the Self-Employed 401(k), however, is that there are more filing requirements and paperwork to administer. The ease and convenience of opening and managing the SEP-IRA continues to be one of its key advantages.
Is a SEP-IRA Right for You?
SEP-IRA plans are designed to allow small business owners or the self-employed to make sizable contributions to a retirement plan without filing a tax form. Employees can contribute up to 25% of their annual income. If you’re self-employed, you can contribute 20% (after subtracting the self-employment tax deduction of your businesses’ net profit or equivalent to the employee percentage given).
However, before jumping in, gather additional information to determine whether it’s the best option for you. Be sure to look into the Self-Employed 401(k), also known as Solo 401(k) and Individual 401(k) plans. These 401(k) plans have “Roth” options for the employee contributions, which are useful for those in a low tax bracket right now. The 401(k) requires more administrative work, however, whereas the SEP-IRA is rather easy to open and administer.
No matter which option you choose, opening a self-employed retirement account and funding it consistently each year is an important part of your retirement planning strategy. Best of luck to you and your business, and kudos to you for continuing to focus on your financial independence.