- A SEP-IRA – or Simplified Employee Pension – Individual Retirement Account – is a retirement savings vehicle used primarily by small business owners and self-employed people.
- SEP-IRAs allow those without access to traditional employer plans to save and invest for retirement while receiving a tax benefit today.
- You are eligible to participate if you’ve turned 21, worked for your employer for at least 3 of the last 5 years, and earned at least $650 in 2021.
- Contribution limits vary between employers and employees. However, these limits tend to be higher than those for standard retirement accounts
Given the events of the past 18 months, it’s no surprise that many people across the globe are finding alternative ways to earn an income. Whether you’ve changed jobs to a smaller employer or started working for yourself, it’s possible that a traditional 401(k) or 403(b) is no longer on the menu.
Enter the SEP-IRA, or the Simplified Employee Pension – Individual Retirement Account. The SEP-IRA is an employer-sponsored retirement account aimed at providing small employers and self-employed individuals a way to save for retirement. The SEP-IRA comes with a variety of eligibility rules and contribution limits, so it’s smart to learn where you stand when it comes to your ability to participate.
The SEP-IRA is intended for small employers and the self-employed, including small business owners and freelance workers. You’re not going to find SEP-IRA enrollment forms at large corporations, educational institutions, or government workplaces — in these environments, you’re more likely to fund retirement savings through 401(k) plans, 403(b) plans, and 457 plans, respectively.
Generally speaking, SEP-IRA eligibility rules allow you to participate if you:
- Are at least 21 years old
- Worked for your employer — even if the employer is yourself — at least 3 out of the last 5 years (this is called the “3-of-5” rule)
- Earned at least $650 in 2021 ($600 in tax years 2016-2020)
One thing to note: an employer can use less restrictive rules, but not more restrictive rules. So, make sure to double check with your employer.
Assuming you meet the eligibility requirements, your employer has created a SEP-IRA plan, and your employer is prepared to make contributions, it’s time to start thinking about contribution limits.
- Employers may contribute the lesser of:
- 25% of an employee’s total compensation, or
- $58,000 in 2021 (increased from $57,000 in 2020)
- Employees may contribute to a SEP-IRA, subject to broader IRA contribution rules:
- $6,000 ($7,000 if you are over 50)
A major takeaway here is that employers have a high contribution limit when it comes to depositing funds to their employees’ accounts. On the other hand, employees are limited to the same $6,000 limit imposed on all IRA contributions. Put another way, employees can only contribute a maximum of $6,000 annually to all IRAs (or $7,000 if you’re 50 or older), and deposits to a SEP-IRA account are included against this limit.
It’s also important to know that if an employer wants to contribute a large percentage of their income to their SEP-IRA, they’ll have to contribute the same percentage (or more) to all employees’ SEP-IRAs. For example, if a small business owner wants to contribute 20% of his income to a SEP-IRA, employees will get the same 20% contributed to their own respective accounts. This is a unique feature of SEP-IRAs, and may result in a large percentage of compensation coming in the form of retirement contributions.
The simple answer is: Yes, SEP IRA contributions are tax-deductible. However, the specifics of SEP-IRA tax deductions depend on whether you are an employer or an employee.
For an employer (e.g. a self-employed business owner), the maximum deduction an employer can take for any given year is the lesser of their contributions or 25% of total compensation So, for example, if an employer earned $100,000 in net income for the year, they would be able to contribute a maximum of $25,000 to their SEP-IRA and take a tax deduction for the same amount.
For employees, the deduction is limited to $6,000 — same as for an standard IRA contribution — and is subject to standard IRA contribution requirements.
Yes, contributions to SEP-IRAs are considered “pre-tax.” Funds grow in the account tax-deferred, and upon withdrawal, you pay standard taxes on the full amount. This is similar to a pre-tax 401(k) or a traditional IRA funded with deductible contributions. In these accounts, like in the SEP-IRA, invested money has yet to be taxed.
Unlike a Roth 401(k) or a Roth IRA, there is no post-tax version of a SEP-IRA. If you want to make post-tax contributions to a retirement account, you might consider funding your SEP-IRA through your employer and then saving any excess funds in a self-funded Roth IRA (if you earn less than the income limits).
You can expect the same withdrawal rules for SEP-IRAs as you would for traditional IRAs:
- You must begin taking withdrawals from your SEP-IRA by April 1st of the year after you turn 72.
- For example, if you turn 72 on July 4th, 2021, you will need to take your first withdrawal by April 1, 2022
- These withdrawals are known as “Required Minimum Distributions”, or “RMDs”
- RMDs increase taxable income in the year of withdrawal
- After your first RMD, you’ll need to take one every year by December 31st
- If you do not take your RMD on time, you will be subject to a 50% excise tax
- Generally, you must turn 59 ½ before you are able to access SEP-IRA funds without penalty.
- In dire circumstances, there are ways to access IRA money using rule 72(t), a method to take equal periodic payments from your IRA.
|SEP-IRA rolling over to…||Is a rollover possible?||Is the rollover taxable?|
While the above table illustrates two common scenarios many investors might encounter, there are many other potential rollover situations with varying tax consequences.
Broadly speaking, you’re able to combine accounts without any tax hit if the tax treatment between the two accounts is the same (e.g. pre-tax to pre-tax, post-tax to post-tax); rollovers involving accounts with different tax treatments (i.e., pre-tax to post-tax) are possible but will result in additional tax liability.
While of course this is a question only you can answer, the SEP-IRA is most typically suited for small business owners with few employees and the self-employed — two groups that typically do not have access to an employer-sponsored retirement plan, like a 401(k) or 403(b).
If, on the other hand, you’re self-employed, freelancing, or simply have a side hustle apart from your day job, a SEP-IRA might work for you. You’ll be able to enjoy significantly higher contribution limits along with a tax deduction in the year of contribution.
Most of the major brokerages offer SEP-IRA retirement plans that can be opened online (with some additional paperwork).
You’ll want to compare your options to make sure you find the right provider. Some common considerations include whether the investment choices are made for you or if you get to pick your own portfolio, the annual fees, and user interface. A lot of this comes down to personal preference, so make sure to do your research to find a good fit.
A 401(k) loan allows you to borrow from your retirement account. Before taking a 401(k) loan, make sure you understand the potential taxes and penalties you’ll owe if you don’t pay the funds back on time, as well as foregone investment gains that could impact your retirement plans.
An Individual Retirement Account – or IRA – is a popular retirement savings account that is tied to an individual, not an employer. Opening an IRA is a pretty simple process. It’s important not to worry about how much you have to invest and to simply focus on getting started as soon as possible.
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