When I crossed over from W-2 employee to being self-employed and co-founded our investment firm, I was excited about the plethora of business retirement plans that I now had at my disposal.

One such option (which ended up being the one I went with) is the Simplified Employee Pension (SEP) IRA. A SEP IRA and traditional IRA is the contribution limits imposed. In 2010, the contribution rules for the SEP are allowable for the lesser of either 25% of your self-employment net earnings; or $49,000.

The other similarity between an SEP IRA and a traditional IRA is the distribution rules. The distribution of both the IRA account and SEP IRA must be taken at some point but some distributions are elective and others will be forced. Penalties and taxes that are applied to both distributions will be dependent on the age of owner at the time of distribution as well as the tax deductions of the assets during the contribution time.

Before the age of 59 ½, any early withdrawal will be subjected to a 10% penalty. This is in addition to federal income tax imposed. There are some exceptions for deferral of the 10% early withdrawal penalty including:

Money Used for Medical Expenses

If withdrawal is made to pay un-reimbursable medical costs, any amount going over 7.5% of the adjusted gross income of the individual for the year will not incur the early withdrawal penalty.

Money Used to Pay Medical Insurance

A penalty-free distribution can be used to pay medical insurance for the individual, their spouse, and any dependents as long as the distribution is necessary due to:

Job loss

Unemployment benefits have been paid by state or federal agencies for 12 consecutive weeks.

The person receiving distributions during the year they receive unemployment compensation or for the next year.

The person receives distributions no later than 60 days after reemployment occurs.

Money Used for a Disability

When an individual becomes disabled before the age of 59 ½ and takes a distribution from their IRA account, the distribution does not incur a penalty. Proof of the disability from a licensed medical provider must be shown that either a mental or physical condition prevents the individual from finding gainful employment.

Money Used to Purchase a First Home

Monies can be withdrawn penalty-free if the funds are used to purchase, build, or remodel a first home for the account holder, their spouse, child, grandchild, or a parent of the account holder. The monies must be used to pay eligible acquisition costs before the end of the 120th day of receiving the distribution of funds. The monies withdrawn for a first home purchase can not be more than $10,000 during the account owner’s lifetime for single individuals. Married couples can withdraw a lifetime total of $20,000.

Money Used for Tax Levy

Monies in an IRA account can be levied by the IRS if taxes are owned which result in a distribution amount. Any distribution amounts will no incur a penalty fee.

Money Used for Educational Expenses

If monies are being used to fund the expenses of higher education of the owner or the dependents of the owner, the amounts will be penalty free. Education expenses that are eligible include tuition, books, supplies, and school fees as part of a requirement for enrollment in a eligible college, university, vocational school, and other post-secondary school participating in student aid programs through the Department of Education.

Beneficiary Distributions

For the SEP program, penalty-free distributions are made from a series of equal payments and must last five years or until the owner reaches the age of 59 ½, whichever time period is longer.

For IRA beneficiaries, if the owner of the account dies before having reached age 59 ½, the distribution amounts for the beneficiary are not penalized.

SEP IRA (Self Employed Pension)

A SEP (Simplified Employee Pension) IRA is the way to go if you’re a small employer (typically less than 10 employees and many times just one employee) looking for a simple retirement plan that’s easy to install and administer. Most financial institutions will have the plan documents on file and it’s as easy as opening up any investment or bank account.  For those of you that don’t know how easy it is, it’s as simple as filling out a couple forms and you’re good to go.   Here are some items that you need to know about the SEP IRA for 2009 , 2010 and 2011.

1. Last Minute Set-Up

The nice thing about a SEP IRA is you can open (or adopt) it at any point up until the due date of the employer’s income tax return, including filing extensions.  If you are small business, a SEP  IRA might be a better option than the Simple IRA or 401k.  I’ve had several business owners who after meeting with their tax professional called me to set up a SEP IRA at the last minute.  Never fun, but at least we know its an option. 

2. SEP IRA’s Are Easy To Set Up

A few forms is all that separate you from having a SEP IRA set up for your business.  SEP IRA’s can literally be set up in a day’s time. In most cases, it is as simple as completing the IRS Model Form 5305-SEP agreement. 401k’s on the other hand, require more up front work to get them set up and maintain.  Also, the administration cost for the SEP are typically very inexpensive compared to its counterpart the 401k.

Although simple, SEP IRA’s have the ability to include more complex features such as social security integration.   If this the case, some sort of special prototype plan would have to be put in place.

3. Benefits To Go

If you are an employee for a business that offers a SEP IRA, once your employer makes a contribution to your account, that money is yours.   That’s different that most 401k plans that usually have some sort of vesting schedule before your money is portable.

4. Employers Don’t File

Unlike a 401k where the employer has to file a IRS Form 5500, that is not required for the SEP IRA.  For any employer that has gone through this process, they realize the time and effort it takes to make sure this form is filed correctly.

5. 2009, 2010 and 2011 SEP IRA Contribution Levels

For 2009 and 2010, you can contribute the lesser of 25% of net earnings from self-employment or $49,000. This is an increase of 20% and $46,000 from 2008.

Update: 2011 limits for SEP IRA’s has remained the same for the coming year.

For example: if you are a business owner and your self-employment income is $40,000 you would only be allowed to contribute $10,ooo ($40,000 x 25%) for 2009.

6. Only The Employer Contributes

Contributions do not have to be made every year and are made by the employer only.  Employees do not make payroll deducted contributions.  If some cases, an employee may be allowed to make contributions to their SEP IRA as a Traditional IRA falling under the IRA contribution limits.

7. Include The Part Timer’s

Part time employees who are 21 years of age who have worked 3 out of the preceding 5 years, earning $500 or more annually, must be covered by the plan which means if you contribute to the plan on your own behalf, you must do the same for any qualifying employee.   Keep in mind that the previously mentioned are guidelines when the employer is required to contribute on the employee’s behalf.  If the employer chooses to contribute to an employee is less than 21 years of age, it is their full discretion.

Extra:

8. Can You Borrow Against a SEP IRA?

Unlike the 401k, the SEP IRA does not have any borrowing provisions.  One bonus to the SEP vs. the Simple IRA is that you are not subject to the 2 year 25% rule.

In conclusion

For most self-employed individuals, the simplicity and effectiveness of a SEP IRA make it a great way to save for retirement and reduce your tax bill even further, especially if you’re down to the wire trying to get any last write off you can.

This information is not intended to substitute specific individualized tax, legal, or investment planning  advice.  We suggest that you discuss your specific tax issues with a qualified tax advisor.