What Is a SEP IRA?

Updated: May 10, 2018

So, you're a small business owner, or self-employed and have realized you too need to start saving for retirement. The Balance explains a SEP (Simplified Employee Pension) below.

If you are a small business owner looking for the best retirement plan to offer employees, or if you are self-employed and earning income, a SEP IRA may be right for you. The SEP stands for simplified employee pension. It is an individual retirement account or IRA, into which employers can make retirement contributions for themselves and their employees.

Compared a 401(k) retirement plan, a SEP IRA is relatively simple to start and manage.

There's far less paperwork and annual filing. Plus, annual contribution limits are much higher than you'll find in most other retirement plans.

As with other tax-advantaged retirement plans, contributions to a SEP IRA can be invested tax-deferred until the money is withdrawn at retirement, beginning at age 59 1/2 and no later than age 70 1/2. If the money is withdrawn before age 59 1/2, it is subject to a 10% penalty fee plus any income taxes. Contributions to a SEP are generally 100% tax-deductible, so you are essentially contributing pre-tax income as you would in a 401(k). For business owners, contributions are 100% tax-deductible as a business expense.

As with other types of IRAs, self-employed people usually have until April 15 (tax day) to make contributions to a SEP for the following year. Meaning you can make contributions to a SEP for 2016 up until April 15, 2017. If you file an extension, you may have until October 15 to fund a SEP IRA for the prior year.

In fact, if you are self-employed, you have the same deadlines for creating a SEP IRA. So you can decide to open a SEP as part of your last-minute tax planning.

SEP IRA Contribution Limits

One of the most appealing aspects of a SEP IRA is its high contribution limits. If you participate in a SEP IRA, you can contribute as much as 25% of your gross annual salary or 20% of your net adjusted annual self-employment income, as long as the contributions do not exceed the maximum of $53,000 in 2016.

The SEP IRA limit is set to increase to $54,000 in 2017. Compare this to the 401(k), which has a maximum contribution limit of $18,000 in 2016 and 2017 (or $24,000 if you qualify for a catch-up contribution), and you can see the obvious benefit for those who are looking to save more tax-deferred dollars.

Even if you participate in another workplace retirement plan, like a 401(k), you can still contribute self-employment income to a SEP. So it's a great plan for people who earn income from a side business, including freelance or contract work.

If you are self-employed, figuring out how much you can contribute each year can be slightly tricky. You can calculate net adjusted self-employment income by taking your gross income, subtracting business expenses and then subtracting half of the self-employment tax. But your contribution to the SEP IRA must be included in business expenses. There are so-called contribution calculators all over the Internet, but none seem to be operating at this level of detail. Consult with an accountant or tax advisor if you have any questions.

You do not have to contribute the same amount each year to a SEP IRA. And if you want to contribute 0% in a given year, that's OK too.

SEP IRA Contributions for Employees

Contributions to a SEP IRA are a little less flexible once additional employees enter the picture. That's because employers must contribute the same percentage for every employee. So if I am a highly compensated professional such as a dentist, and I want to contribute 25% of my income to a SEP, I must also contribute 25% of each of my employees' salary to a SEP as well. All employees who are age 21 or older, have worked for the employer for three of the past five years, and earn more than $550 are eligible for this contribution. (Although employees working under union agreements may be excluded. Consult the IRS for more on this).

There are other retirement plans for small businesses and self-employed individuals, such as SIMPLE IRAs, individual or solo 401(k)s, Keoghs, or even regular 401(k)s for small businesses.

It makes sense to compare them all before deciding which one is right for you.


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