What is a SEP IRA and how it can help you save money for retirement?

Today, we will be talking about the retirement plans for those that are self-employed or own small businesses. This plan is also known as SEP – or Simplified Employee Pension – which provides business owners with a simplified method to contribute toward their employees’ retirement as well as their own retirement savings

In this article we will discuss what is a SEP IRA and how it can help you save money for retirement?  I will discuss about who can contribute to a SEP IRA? How much can you contribute each year? Are the contributions tax deductible? When can you take money out? What are the benefits? Advantages and Disadvantages of SEP IRA accounts and so much more! 

O.K. so let’s get started!

What is SEP IRA?

SEP IRA stand for: Simplified Employee Pension  Individual Retirement Account. In essence, this is a retirement account for business owners and self-employed individuals.

SEP IRA contributions are tax-deductible, and investments grow tax-deferred until retirement. Once you retire and are ready to take distributions, then you will pay taxes on the distributions.

Any employer may establish a SEP plan. This includes sole proprietorships, partnerships, corporations and non-profit organizations.

Now, let’s see who can contribute to a SEP IRA?

When it comes to contributions, there is a very important rule set by the IRS- The rule says that if a small business has employees who are eligible participants in the SEP plan, the business must make contributions on behalf of employees equally to the contributions of the business owner. So, if the business owner has 3 employees and decided to contribute $5,000 towards the SEP IRA account for eligible participants, then the business has to make the same contributions to everyone including to the owner itself.

Generally, employees must be allowed to participate if they're 21 or older, earn at least $600 annually (limit for both 2017 and 2018), and have worked for the same employer in at least three of the past five years.

What are the contribution limits?

In one of our previous videos about Traditional IRA we discussed that it allows individuals to contribute up to $5,500/ year in 2018 ($6,500 if you’re 50 or older). With a SEP IRA, you could contribute up to $55,000 for year 2018.

The maximum contribution can't exceed the lesser of:

·         25% of the employee's total compensation* or

·         $55,000 for the 2018 tax year.

*Net compensation for self-employed individuals is generally the net profit from IRS Schedule C reduced by the deductible self-employment tax. The eligible compensation limit, indexed for inflation by the IRS, is $275,000 for year 2018.

Contributions are deductible as a business expense and not required every year.

Employee Contributions:

·         Up to $5,500 for the 2017 and 2018 tax years (or $6,500 if age 50 or older).

·         This is the total amount the employee can personally contribute to all SEP-, Roth, and traditional IRAs each year.

Now, let’s talk about When You can Take Money Out of SEP IRA account?

You can withdrawal or take a distribution from your SEP IRA at any time, but It’s so important that you know the rules regarding distributions from a SEP IRA in order to avoid paying the penalty for early distribution.

·         If you are OVER the age of 59.5: Your full distribution will be taxed as ordinary income for the year in which you take the distribution.

·         If you are UNDER the age of 59.5: Your full distribution will still be taxed as ordinary income for the year you take the distribution BUT you will also be taxed a 10% penalty.

This is one of the most important things I want you to remember-  If you decide to take a distribution before you are 59.5, not only will you be paying regular income taxes on the full distribution amount but you will also pay a 10% penalty for taking an early distribution. I would never recommend you take distributions from your Traditional IRA before age 59.5.

There are exceptions to this rule, and I will address it in a separate post.

So, really what are the benefits of a SEP IRA?

1. 1. Easy to set up and administer: Well, one of the obvious reasons of investing money in the SEP IRA is that you create a pension fund for your retirement. The money grows tax free. Another advantage is that the amount that you invest each year can be a tax deduction. 
   
2. Contributions are tax-deductible, including those made to employee accounts. You can deduct the lesser of your contributions or 25% of compensation, subject to the $270,000 compensation cap. If you’re self-employed, your deduction is 25% of net self-employment income.
3. SEP IRA can be combined with a Traditional IRA or Roth IRA
4. Flexibility: You don't have to commit to contributing every year

Let’s also look at some disadvantages of IRA

-       Required proportional contributions for each eligible employee if you contribute for yourself

-       Distributions before age 59½ are taxed as income and subject to a 10% penalty (same as Traditional IRA)

-       Just Like traditional IRAs and 401(k)s, SEP IRAs require minimum distributions beginning at age 70½

-       There is no catch-up contribution for those who are 50 years or older.

-        No Roth version, which means you can't opt to pay taxes on contributions now and take distributions tax-free in retirement, as you can by choosing a Roth IRA. Distributions are taxed, so if your tax bracket in retirement will be higher or if the tax law changes unfavorably, then your distributions will be taxed at a higher rate

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