SEP IRA: What Is It and How Does It Work?

Posted on Mar 3, 2017

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SEP IRA

Source: betterment.com

If you’re an entrepreneur or self-employed, no one provides you with a pension plan. It’s important to build a retirement fund to support yourself and/or your dependents when you retire. If you have employees, you may also want to set up a retirement plan for them, and enjoy some tax breaks in the process!

Enter the Simplified Employee Pension plan, also known as an SEP or SEP IRA. Let’s look at what this plan offers, how it works, and how you can use it.

What is a SEP IRA?

SEP IRAs are employer-sponsored retirement plans that allow employers to make tax-deductible contributions to a retirement fund on behalf of an eligible employee. Business owners and self-employed individuals can also use these IRA-based plans to save money for their own retirement, whether they work full-time or part-time.

Setting Up an SEP IRA

SEP IRAs are easy and inexpensive to set up, and available to businesses of any size, including sole proprietors, partnerships and corporations. The account needs to be opened with any qualified financial institution such as a bank or insurance company, after completing Form 5305-SEP.

Employees and business owners need to have a traditional IRA to be eligible for an SEP. It’s often easiest to open and maintain SEP IRAs for eligible employees if a single financial institution is used for all the accounts.

SEP IRA Rules to Keep in Mind

Business owners who set up an SEP IRA for themselves also have to create one for each eligible employee, and offer a uniform contribution rate for everyone. If you as an employer put 10% of your pay into an SEP IRA, you must contribute an equal percentage of each eligible employee’s pay as well.

Tax-deductible contributions to SEP IRA plans can be made up to the employer’s tax filing date. You can also opt not to make any contributions during a slow year, but then you cannot make an SEP IRA contribution for yourself either.

How Does an SEP IRA Work?

SEPs are quite similar to traditional IRAs, and here are some basic points about how they work:

Ownership and Control – Employees and business owners retain control of the account, and are responsible for choosing which stocks, mutual funds or other vehicles their funds will be invested in.

  • Portability:
    Employees and business owners can take the account with them if they leave an employer or the business closes down. They can also opt for a transfer or rollover of these funds to another IRA or 401(k).
  • Contributions:
    Employees cannot choose how much their SEP IRA contribution will be, and cannot make contributions on their own behalf. Employers decide what percentage of pay will be contributed for every eligible employee on an annual basis, if any.
  • Distributions:
    Withdrawals from the plan are taxed as ordinary income to the owner of the account. Distributions also incur a 10% early withdrawal penalty if they are made before the account owner turns 59½. Like traditional IRAs, required minimum distributions begin after 70½ years of age.
  • Taxes:
    Employers can claim employee contributions as deductions on business tax returns. Sole proprietors’ contributions can be claimed on personal tax returns. Contributions do not incur taxes for the account owner, but earnings such as interest or gains from investment are taxable.
  • SEP IRA Contribution Limits:
    TheSEP IRA contribution limit is higher than standard IRAs, and employers can contribute up to $53,000 or 25% of an employee’s eligible compensation, whichever is lower. If an employee owns another defined contribution plan, the total annual contribution for both cannot exceed $53,000.

Remember, SEP IRA contribution for self-employed individuals is more complex, so it’s a good idea to consult a professional for expert advice. At Self-Directed Retirement Plans, our advisors would be glad to help with your questions. Call us to discuss your retirement planning needs today!

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