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A good part of the working population in the United States has some type of retirement plan investment account.
Most individuals contribute to either an employer-sponsored retirement plan like a 401(k) account or a Traditional Individual Retirement Account, known by the IRA acronym.
People who may not be permitted to participate in these retirement savings options are self-employed workers and small business owners with few to no employees.
To provide self-employed Americans with access to retirement savings accounts, the federal government, through the Internal Revenue Service (IRS), offers small business owners some retirement savings options of their own.
One such plan we'll explore in this article is the Simplified Employee Pension Individual Retirement Account (SEP-IRA).
What is a SEP-IRA?
Essentially, a SEP-IRA plan functions much like a Traditional IRA, allowing you to save for the future in a tax-advantaged way.
The only differences between these two retirement savings options are who can participate and the amount of money they can contribute to the account.
Who is Eligible to Participate in a SEP-IRA?
The SEP-IRA is available to self-employed individuals, owners of small businesses with very few to no employees, or those earning a freelance income.
This includes a sole proprietor, partnership, limited liability company (LLC), and C or S corporations.
If a small business owner has employees, they'll likely need to offer SEP-IRA access to those eligible employees.
Furthermore, they'll face requirements to make a plan contribution to the SEP-IRA accounts of their employees based on IRS equal percentage of compensation rules.
These rules apply if the employee meets the IRS definition of a SEP eligible participant.
That definition is tied to the following criteria:
- The employee must be 21 years of age or old
- The employee must have been employed in three of the prior five years
- The employee must have earned $600 in the previous five years or $650 in the current year for the applicable employer
- The employee must receive a contribution from the employer equal to the percentage of salary amount the self-employed person contributes to themself
Given this employee contribution requirement, which could be significant, it's easy to see why the SEP-IRA option works best for business owners with no employees.
But it's a good option for entrepreneurs with few employees who want to provide retirement contributions to those they employ.
Note: Employees getting contributions from their employers will have control over their individual SEP-IRA accounts.
Each year, SEP-IRA participants are allowed to make contributions of their taxable income to their SEP-IRA accounts at any time during the year.
In fact, a deductible contribution up to the maximum contribution limits can be made for the prior year in the current year, up until the participant files their tax return in April.
One of the primary differences between a Traditional IRA and a SEP IRA is the amount participants can contribute annually.
With a SEP-IRA, the participant can make yearly contributions equal to the lesser amount of 25% of their net income for the given year or a cap limit set by the IRS. (The cap limit is $66,000 in 2023.)
Note: These very same maximum limits apply to the funds contributed for employees. Also, the 25% is limited to the first $330,000 of compensation in 2023. SEP-IRAs do not have a “catch-up contributions” provision of any kind.
The SEP-IRA provides a tax advantage in that all contributions are made from pre-tax earnings.
That means the account holder will not have to pay taxes on the contributions until later (see the distributions section below). These contributions are considered tax-deferred contributions.
Note: If employers make qualified contributions on behalf of employees, those amounts are tax-deductible on the employer's personal or business tax return, depending on the business owner's tax filing status.
Since SEP-IRA contributions are made on a tax-deferred basis, taxes will be due in the future when taking a distribution from the account.
SEP-IRA participants are allowed by law to take distributions at any time.
However, any distributions taken before the age of 59 1/2 will be subject to a 10% tax penalty, on top of the participant's statutory tax rate.
All distributions after age 59 1/2 will not be subject to a penalty unless the participant fails to start taking distributions by age 72 (or age 70 1/2, see below).
Remember, taxes will be due on all distributions, including those from the SEP-IRA's growth earnings.
Since the U.S. Government and IRS know that circumstances can force participants to take distributions early, there are situations under which the IRS could waive the penalty amount.
These circumstances include:
- Participant becomes disabled
- Death of the participant (death certificate required)
- A series of substantial and equal distributions
- To cover higher education costs of children or the participant
- First-time home purchase (max of $10,000)
- To satisfy an IRS levy
- To cover certain medical costs as defined by IRS
- To cover medical insurance while unemployed
- Call to military service
In all of these circumstances, the participant is still responsible for paying taxes based on their statutory tax rate.
There are no minimum or maximum amounts that participants can withdraw after age 59 1/2.
Still, you generally must start taking required minimum withdrawals from your SEP IRA when you reach age 72 (70 ½ if you attain that age before January 1, 2020).
At that time, the IRS requires participants to begin taking distributions at their statutory tax rate based on their required minimum distributions (RMD) calculation.
This calculation is based on life expectancy criteria. To avoid penalties, participants in this category need to ensure they calculate the right amount.
Can Individuals Participate in Both a SEP-IRA and a 401(k)?
Yes, individuals can participate in both, but there are limits on pre-tax contributions.
Between the two options, employees can contribute up to statutory limits. But there's a maximum amount that can be counted as tax-deferred.
That amount is called the “basic elective deferral limit”, which has been set at $22,500 for 2023. The employer contributions are capped as well. See IRS Guidelines.
Can Individuals Participate in Both a SEP IRA and a Traditional or Roth IRA?
Yes, individuals can have contributions in both a SEP-IRA and a traditional IRA up to statutory contribution levels for both plans.
However, the tax-deductibility of those contributions with net income of over $73,000 ($116,000 if married, filing jointly) would not be 100% deductible.
If income is over the $73,000 threshold, a portion of the traditional IRA could be rolled into a Roth IRA which provides tax-free growth on contributions.
Benefits of Participating in a SEP IRA
The motivation for an entrepreneur to choose a SEP IRA as their small business retirement plan comes from a number of benefits they would derive by doing so.
The potential benefits include:
- Easy application process and account maintenance
- Generous contribution levels
- Flexibility in contribution amounts from one year to the next
- Deferring of taxes until distributions are taken
The biggest potential disadvantage of a SEP IRA comes from the requirement to fund employee accounts to the same level as the business owner.
Some self-employed individuals may do better with a different tax-advantaged retirement plan depending on their business and retirement goals.
Sole proprietors, freelancers, independent contractors, and other self-employed persons without employees, or those who only employ a spouse may choose to go with the popular Solo 401(k).
Seek the advice of a financial advisor or tax professional if you have any questions about eligibility requirements or which type of retirement account would provide the most tax benefit for you.
They'll each offer a range of investment choices to suit your risk tolerance, such as stocks, bonds, ETFs, mutual funds, and more.
Because administrative costs and plan expenses may vary, check with multiple providers before choosing one.