Are you a self-employed business owner that is looking for a cost-effective way to lower your taxes and help you save for retirement?
If that fits your profile then opening a SEP (Simplified Employee Pension) IRA might be a good retirement account to start for your business.
When I was researching what would be the best retirement plan to set up for myself when I first became self-employed, I narrowed it down between the SEP IRA and the Solo 401k.
Both allowed very favorable contribution limits, but the administrative costs and ease of setting up made the SEP IRA the easy answer.
If you are considering opening a SEP IRA for your business, here’s what you need to know about the SEP IRA rules and contribution limits and how easy it is to open one.
What is a SEP IRA?
Table of Contents
- What is a SEP IRA?
- SEP IRAs Have Tax-Deferred Compounding
- SEP IRA Contributions are Discretionary.
- How Much Can You Contribute to a SEP IRA?
- What Makes Employees Eligible for a SEP IRA?
- What’s the difference between a SEP IRA vs a Simple IRA?
- Three Reasons You Should You Open a SEP IRA
- Where Can I Open a SEP IRA?
- The Bottom Line – Opening a SEP IRA
- FAQs on SEP IRA Rules
A SEP IRA (Simplified Employee Pension) is a type of employer-sponsored retirement plan that allows business owners and self-employed individuals to make contributions to traditional IRA accounts for themselves and their employees.
The contributions are tax-deductible and the money in the account grows tax-deferred until it is withdrawn in retirement. SEP IRA plans are designed to be simple and easy to set up and maintain.
Employers can establish a SEP IRA plan with minimal paperwork and low administrative costs, and contributions can be made for all eligible employees regardless of whether they choose to contribute to the plan or not.
SEP IRAs Have Tax-Deferred Compounding
Just as a traditional IRA or 401k, your contributions are pre-tax and can significantly lower your taxable income.
You contribute pre-tax dollars to a SEP IRA, and that has the effect of lowering your tax bill. The money in the IRA grows tax-deferred, and your business doesn’t pay any taxes on the IRA earnings. The assets can be invested in many ways.
The traditional IRA rules apply. When you take the money out of a SEP IRA for retirement, you pay ordinary income taxes on it. (Should you withdraw SEP IRA assets before age 59½, you’ll likely be assessed a 10% penalty, with some exceptions.)
SEP IRA Contributions are Discretionary.
One huge bonus for business owners is that you are not required to contribute to a SEP IRA each year. In addition, there is not a set amount that you have to put in. This flexibility is priceless for a business owner that has fluctuating net income year after year.
Also, you are not subject to the typical IRA deadline to contribute: April 15th. If you file a tax extension, you can wait until then to make the contribution.
How Much Can You Contribute to a SEP IRA?
In 2023, you can contribute up to 25% of an eligible employee’s compensation, up to a limit of $66,000. That amount is increased by $5,000 from 2022. While that increase may seem minimal, over time it will have a sizable impact on your retirement.
Catch-up contributions are permitted for older employees, increasing the total contribution by $6,500 to $66,000. Based on the 25% rule the income threshold should be $264,000, but it’s not quite that simple. The actual maximum qualifying income for 2023 is $330,000.
Now I just said that you can contribute 25% of your income, up to a total income of $330,000. But $330,000 at 25% would be $82,250, which isn’t right. And that’s where the maximum contribution gets a little bit more complicated.
Under the IRS’s convoluted calculations, in order to come up with the 25% contribution amount, you must first deduct the amount of the contribution from your income. Got that?
For those of you who follow the math, it works out to be – effectively – 20%. That’s how you get the maximum contribution of $66,000 on a $330,000 income.
By deducting $66,000 from $330,000, you get $264,000. And if you multiply 25% times $264,000, you arrive at the maximum contribution of $66,000. I said the calculation was convoluted, and this is what I mean. But for our purposes, you should assume that you can contribute 20% of your income to a SEP IRA. (If you want to do a deep dive into how this works, check out the IRS formula for calculating the contribution.)
|YEAR||MAXIMUM ANNUAL CONTRIBUTION||MAXIMUM CONSIDERED COMPENSATION|
What Makes Employees Eligible for a SEP IRA?
If you have employees, then provided they pass a series of tests, you will have to contribute the same percentage to them – just based on their salary- not yours. Generally, employees of a small business are eligible for a SEP IRA if they:
- Are older than 21
- Have worked for the business in at least three of the five years preceding the year in which the IRA contribution is made
- Have received $750 or more in compensation from the business in 2023 (this can rise with COLA adjustments in future years). However, the IRS states that an employer “may use less restrictive requirements to determine an eligible employee.”
However, the IRS states that an employer …
“may use less restrictive requirements to determine an eligible employee.”
Employees covered by a union contract may be excluded from a SEP, as well as non-resident aliens who have not earned income from your business.
All eligible employees must participate in the SEP, including part-time and seasonal workers and employees who die, quit, or get laid off or fired during the year.
Setting Up a SEP IRA and Maintaining Filing Requirements
In order to set up a SEP IRA you first need to choose the trustee for the plan. That can be a bank, a mutual fund family, a diversified investment brokerage, or a managed investment account.
That must be followed by three additional steps:
- Execute a written agreement to provide benefits to all eligible employees.
- Give employees certain information about the agreement.
- Set up an IRA account for each employee.
The plan trustee can help you with all of the set-up steps. The written agreement must include the name of the employer as well as the requirements to enable employee participation. It must also include an allocation formula, and be signed by you or another responsible official in your business.
The IRS even provides Form 5305-SEP, Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement for this purpose, though the form does not need to be filed with the IRS.
If you don’t want to use the 5305, the trustee that you select to administer the plan almost certainly has their own document format for you.
Once the trustee and the written agreement have been established, you must provide any employees with the following:
- Notice that you have adopted the SEP
- Any requirements for receiving the allocation
- The basis on which the employer contribution will be allocated
Important: You must also provide your employees with a copy of the completed Form 5305-SEP, or other written agreement used, as well as instructions for the form. It is not considered adopted until each employee is provided with the following information:
- A statement that IRAs other than the one the employer contributes to may provide different rates of return and contain different terms.
- A statement that the administrator of the SEP will provide a copy of any amendments within 30 days of the effective date along with a written explanation of its effects.
- The administrator will give written notification to the participant of any employer contributions made to a participant’s IRA by January 31 of the following year.
You and each of your employees will get a statement from the plan trustee at the time you make your first contribution, and at least annually thereafter. The trustee must also provide a plain language explanation of any fees or commissions that it will charge on funds withdrawn from the plan.
The plan can be set up as late as the due date of your business income tax return for the year in which you want to establish the plan, including filing extensions if necessary.
What’s the difference between a SEP IRA vs a Simple IRA?
The SEP IRA and Simple IRA (Savings Incentive Match Plan for Employees) are both types of employer-sponsored retirement savings plans, but they have some important differences:
- Eligibility: SEP IRA plans are open to employers of any size, including self-employed individuals, while Simple IRA plans are only available to employers with 100 or fewer employees.
- Employee contributions: Employee contributions are not allowed in a SEP IRA plan, while employees can make contributions to a Simple IRA plan.
- Employer contributions: Employers are required to make contributions to a Simple IRA plan, either by matching employee contributions dollar-for-dollar up to 3% of compensation or making a non-elective contribution of 2% of compensation for all eligible employees. In contrast, there are no employer matching contributions required for a SEP IRA plan, but employers are required to make contributions to the plan.
- Contribution limits: The contribution limits for a Simple IRA are lower than for a SEP IRA. For the year 2023, the contribution limit for a Simple IRA is $15,500 for individuals under age 50 and $19,000 for those 50 and older, while for SEP IRA is the lesser of 25% of the employee’s compensation or $66,000.
- Penalties for early withdrawals: Both SEP IRA and Simple IRA plans have penalties for withdrawing funds before reaching age 59.5.
Three Reasons You Should You Open a SEP IRA
If you’re in a position to open up a SEP IRA then you definitely should. It’s one of the very best self-employed retirement plans available.
Here are three reasons why this plan stands out above every other:
1. Fast Retirement Savings Build-up
At $66,000, or $73,500 if you are 50 or older, the SEP IRA offers one of the highest contribution limits possible. This is far higher than what you can get with a traditional or Roth IRA, or a SIMPLE IRA. Think about how quickly you could accumulate a seven-figure retirement portfolio making that kind of contribution each year?
By contributing $66,000 per year, with an investment return of 7% per year, your plan could pass $1.1 million in just 12 years. That means that if you start a SEP IRA at age 30, you will be a millionaire by the time you’re 42, just on your retirement plan alone.
Let’s take it a step further. If you continue the same contribution pattern until the age of 50, you would have nearly $2.3 million after just 20 years of making contributions. That looks like a recipe for early retirement, don’t you think?
2. Creating a MAJOR Income Tax Deduction
But moving past the rapid portfolio build-up, let’s consider another major advantage of the SEP IRA – tax-deductibility. $66,000 is a massive reduction in your taxable income. Assuming that you’re in the 22% tax bracket for federal income taxes, and 6% for state income tax, you would save $16,240 in income taxes each year.
3. The Ability to Expand a SEP IRA to Cover Employees
If you have employees in your business, or you plan to have them going forward, a SEP IRA can easily accommodate them. But there is one quirk in adding employees to a SEP IRA. Since it is an IRA, as in an individual retirement account, you can sponsor the plan, but each employee within the plan will have to open up his or her own account.
That’s a minor inconvenience, but one that will enable you to easily transition from sole practitioner status, to having employees with a retirement benefit. And in today’s job market, offering a generous retirement plan is a virtual requirement for attracting the best talent to your business.
And believe it or not, there’s actually a secondary benefit for the separate accounts. Since each employee will have an account in his or her own name, they will each be responsible for investment choices made within their accounts. That will relieve you as the employer from having any responsibility to choose and manage investments in each individual plan.
If you’re looking to open up a retirement plan for your business, you owe it to yourself to thoroughly check this plan out.
Where Can I Open a SEP IRA?
Opening a SEP IRA is just as easy opening a regular investment account. You can open up one of these plans with the help of almost any financial advisor or financial institution. Some of my favorite providers include:
Betterment rebalances for you and gets you out of investments that are underperforming. For anyone who wants a hands-off approach to their SEP IRA, Betterment offers a great solution with very low costs.
M1 Finance is an innovative robo-advisor that lets you play a hand in your retirement investments. If you’re a self-employed individual or small business owner and you want the convenience of a robo-advisor with the control of a self-managed account, M1 could be an excellent choice for your SEP IRA. You can contribute up to age 70 1/2, at which time there are required distributions.
With zero advisory fees, expert advice, and automated account management, M1 Finance makes investing for retirement a breeze. While there is no deposit required to open an M1 account, there is a $500 initial requirement to begin investing in a SEP IRA.
M1 investments, referred to as pies, are composed of up to 100 ETFs and stocks. M1 has crafted 60 pies for targeted investment goals, but you can also build your own.
Ally Invest is an excellent investment platform for SEP IRA accounts on at least two fronts.
The first is cost. Ally Invest has no annual fee and commissions are $0 per trade, which is rock bottom for the industry. The second is the investment platform itself. It has all the tools and resources you need if you want to use your account for active trading. There are virtually unlimited investment options, including and especially options trading. They also offer extended hours trading, enabling you to place trades up to 1 ½ hours for the market opens, and up to one hour after it closes.
Ally Invest is a perfect investment platform for the do-it-yourself investor, and particularly if you are an active trader. But they also offer several managed account options at very reasonable fees. That means that you can have part of your money professionally managed, while you go the DIY route with the rest of your account.
TD Ameritrade is on this list for one reason and that is ETFs. While their process for starting your account is just as easy as any other online brokerage, they offer one feature that sets them apart; FREE ETF TRADES. TD Ameritrade offers more than 100 exchange-traded funds that you can trade for free. This is the most generous offer of any of the online brokerages. If you want an inexpensive way to invest your SEP IRA investments then TD Ameritrade offers you a hands-on approach with no fees.
E*TRADE is an excellent investment platform for long-term investors – which is really what you want to have for a retirement plan. And since they offer virtually every type of investment plan and retirement plan available, you can have several accounts with the same broker.
Their trading fees are $0 and they offer 2,700 no-load, no transaction fee mutual funds. They’re also one of the better platforms when it comes to service levels. You can get as much or as little broker assistance with your account and trading activities as you choose. If you want a fully managed account, can get that through E*TRADE Capital Management.
You can even have other retirement plans at your business in addition to SEP IRAs, and you can set up a SEP IRA for your small business even if you are already participating in another retirement plan at another company.
Sole proprietors, partnerships, and corporations can all create SEPs. In fact, they may qualify for annual tax credits of up to $500 during the plan’s first three years, which can be applied toward the plan’s start-up costs.
So if you have a small business or work on your own and you want a retirement plan that works for your future without a lot of hassles, a SEP IRA may be right for you.
The Bottom Line – Opening a SEP IRA
In conclusion, a SEP IRA is a great retirement savings option for small business owners and self-employed individuals, as it allows them to make tax-deductible contributions on behalf of themselves and their employees. The contribution limits for a SEP IRA are high and flexible, making it an attractive option for those looking to save for retirement.
However, it’s worth noting that employees are not allowed to make contributions to their own SEP IRA account. As with any retirement savings plan, it’s important to consider the fees, investment options, and other features of the plan, as well as the income limits, before making a decision.
It’s always best to consult a financial advisor and your tax professional to ensure that a SEP IRA is the best option for you and your employees.
FAQs on SEP IRA Rules
Employers, including self-employed individuals, are eligible to establish a SEP IRA plan and make contributions on behalf of their employees. However, the employees are not allowed to make contributions to their own SEP IRA account.
No, there are no employer matching contributions required for a SEP IRA. Employers are only required to make contributions to the SEP IRA on behalf of their employees.
Yes, there are penalties for withdrawing funds from a SEP IRA before reaching age 59.5. These withdrawals are subject to a 10% early withdrawal penalty in addition to any applicable income taxes.
Employers can increase their SEP IRA contributions by adjusting the amount they are contributing to the plan. Keep in mind that the contribution limit must be followed.