As a self-employed person, saving for retirement may feel difficult, since you have to set aside so much money to cover your taxes. Contributing to a Simplified Employee Pension (SEP) individual retirement account (IRA), however, can substantially lower your taxable income. Employers with just a few employees may benefit from SEP IRAs as well; learn more below.
What is a SEP IRA?
A SEP IRA is a type of individual retirement account intended for business owners with few or no employees. Self-employed people and freelancers are among the intended user base for SEP IRAs as well. It's common for accountants to advise their self-employed and freelance clients to open SEP IRAs. That's because all contributions to SEP IRAs are tax-deductible, and the contribution limit is relatively high. Since self-employed people typically pay more taxes, the potentially large tax deductions that SEP IRAs introduce make them especially beneficial for freelancers.
Whether you're a freelancer or a business owner with just a few employees, your SEP IRA contributions will grow tax-deferred. In retirement, withdrawals from a SEP IRA are taxed as personal income.
Who qualifies for a SEP IRA?
SEP IRAs are intended for freelancers, self-employed individuals and business owners with just a few employees, but additional qualifications exist. Employees qualify for a SEP IRA if they are 21 or older, or they have worked for you during three of the last five years. Given these rules, any sole proprietor or freelancer 21 or older can open a SEP IRA.
If you have employees who don't meet the above qualifications, but you would still like to include them in your SEP IRA, you can set your own qualifications. Through IRS Form 5305-SEP, you can lower the minimum age or years worked qualifications for your SEP IRA. However, you cannot change your rules to disqualify employees 21 years or older who have worked for you during three of the last five years.
How do SEP IRAs work?
Signing up for a SEP IRA account is easy, as is administering one. You and your employees can also combine your SEP IRAs with separate traditional or Roth IRAs. And with SEP IRAs, you're not required to contribute annually as you might be with other retirement plans.
On the flip side, SEP IRAs lack the catch-up contribution abilities that other retirement accounts have. You also can't invert the SEP IRA model of tax-deferred growth and taxed retirement withdrawals so that you pay taxes now instead of in retirement. Withdrawals taken before age 59 1/2 usually come with a penalty, and minimum distributions are required from age 72 onward.
Perhaps most importantly with SEP IRAs, if you have employees and you contribute a certain percentage of your income to your own SEP IRA, you must contribute the same percentage of all qualified employees' incomes to their accounts. For example, if you contribute $6,000 (10%) of your $60,000 income to your own SEP IRA and pay your sole employee $45,000 per year, you must also contribute $4,500 to their SEP IRA.
What are the SEP IRA contribution limits?
The SEP IRA contribution limit for 2021 is either 25% of an employee's income or $58,000, whichever is smaller. Note that IRS Form 5305-SEP says the contribution limit is $41,000, but this amount is inaccurate. Form 5305-SEP has not been revised since December 2004, when the limit was indeed $41,000. The form also indicates that the SEP IRA contribution limit is "subject to annual cost-of-living adjustments," explaining the current $58,000 limit.
As an employer, you will only contribute to your employees' SEP IRAs based on the first $290,000 of their income. Again, this 2021 value differs from the amount given on Form 5305-SEP given cost-of-living adjustments.
Combining the above criteria into some examples may help. If you have one employee whom you pay $50,000 each year, you can contribute at most $12,500 (25%) to their account. If you are self-employed and make $300,000 per year, the final $10,000 of your income does not count for SEP IRA purposes.
SEP IRA rules
The rules for SEP IRAs can be broken down into three categories:
- Investment: You cannot invest your SEP IRA in life insurance or collectibles. If you invest your SEP IRA money into collectibles, your investments are counted as distributions and taxed and penalized accordingly. SEP IRA trustees may set additional rules of their own – a common provision is a ban on investing in real estate.
- Distribution: Withdrawing money from your SEP IRA before retirement is highly discouraged (though not forbidden). Not only are your withdrawals added to your taxable income, but you face a 10% penalty if you're under the age of 59 1/2. That said, unlike with some other retirement accounts, you don't need to prove hardship to withdraw funds. Either way, you're required to begin taking distributions once you reach 72 years of age.
- Rollout: If you receive any pre-retirement payments from your SEP IRA, you can roll them over by depositing them in another IRA. In doing so, you avoid paying taxes on these payments. You can manually deposit these payments into another account, or you can have your plan administrator or provider do so for you.
What are the tax implications of a SEP IRA?
A self-employed individual or employer with a SEP IRA can deduct either their total contributions or 25% of their income – whichever is smaller – from their taxable income. For example, if you're self-employed and you've invested $60,000 into your SEP IRA from an income of $200,000, you can't deduct $60,000 from your taxes, since that's more than 25% of your income. Instead, you can only deduct $50,000, which is 25% of your income.
Beyond deductibles, SEP IRAs are largely the same as traditional IRAs when it comes to growth and retirement distributions. Your investments will grow tax-deferred, and when you begin taking required minimum distributions from age 72 onward, you'll pay income tax on your withdrawals.
How to get started with a SEP IRA
Starting a SEP IRA for yourself or your small group of employees is simple. Just follow the below steps:
- Complete IRS Form 5305-SEP. Although you won't need to file this form with the IRS, most SEP IRA providers technically require you to complete it. Once complete, store your form in your digital asset management system.
- Inform your employees about your SEP IRA. After you complete and save your Form 5305-SEP, you should distribute it to your employees to inform them of your SEP IRA offerings. Of course, given that this form is a federal tax document, you may want to explain how your SEP IRA works in plain language.
- Create separate SEP IRAs within your account. Employees who opt into your SEP IRA should get their own account. Most providers make setting up this account easy for small business owners.
In general, SEP IRAs are among the more hassle-free benefits programs you can establish. If you face any challenges, your provider's customer support team should be happy to help.