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Tom
July 15, 2020

What is a SEP IRA?

Simplified Employee Pension IRAs or SEP IRAs are retirement accounts primarily utilized by self-employed individuals or smaller employees. SEP IRAs are part of SEP Plans; the IRA is just the vehicle that carries the financial assets to retirement.

Unlike Traditional or Roth IRAs a SEP IRA is not primarily funded by the employee. The employer funds the SEP portion of the IRA.

The only time an employee would contribute to a SEP IRA would be if the company holding the SEP allowed the IRA to be treated like a Traditional IRA. If so, standard Traditional IRA rules apply.

The employer is allowed to write off the contributions as a business expense. The only catch is every employee must get the same contribution percentage.

For example, if a small employer with an owner and five other employees utilizes the SEP with a 10% contribution for the owner the business must also contribute 10% into the SEP accounts of the five other employees.

SEP IRA Rules

Here are the rules you need to be aware of with SEP IRAs:

SEP IRA Eligibility Rules

Any employer may open up a SEP Plan for its employees. This includes self-employed individuals with no other employees.

The individual employees do not create the SEP Plan. Those employees are allowed to open up Traditional IRAs that accept SEP IRA contributions. Once the Traditional IRAs have been opened the SEP Plan makes contributions into that IRA on the employee's behalf. (Thus a SEP IRA is really a Traditional IRA that accepts a different type of contribution.)

Employees are eligible to participate (in most cases) in the SEP Plan and accept SEP IRA contributions from their employer if they meet these rules:

  • They are age 21 or older.
  • They earn $550 or more during the tax year.
  • They have worked for the employer three of the past five years.

Editor's Note: Why I Chose a Gold IRA as an Entrepreneur

SEP IRA Contribution Limits

Individual contribution limits for Traditional and Roth IRAs currently sit at $5,500 per year (or $6,500 if you are age 50 or older). 401k plans have limits at $17,500 (or $23,000 if you are age 50 or older).

Those are both a great way to get started toward saving for retirement, but wouldn't you love to be able to contribute more? Plus, a 401k plan can be complicated and expensive to administer for a small business owner.

Enter the SEP IRA. With this plan the employer may — at its discretion — contribute up to 25% of an employee's compensation up to a $52,000 limit. (The $52,000 limit is for the 2014 tax year; future limits will be tied to inflation.)

If you make $40,000 per year and your company elects to contribute 15% to all employees then you would get $6,000 deposited into your SEP IRA. But if you make more than $208,000 per year — the maximum amount to reach the $52,000 contribution limit — you won't get any more than $52,000 contributed to your SEP IRA for that tax year.

SEP Contribution Methods

Employers may elect to contribute up to 25% of their employee's compensation into a SEP IRA, but they don't have to. In fact there are three methods of SEP contribution:

  • a set percentage: every employee receives the same percentage whether that is 1%, 10%, or 25% of pay
  • a flat amount: every employee receives the same, flat amount of money rather than a percentage; e.g. everyone receives $3,000
  • a Social Security Integration formula: this one is complicated. Instead of a set percent or flat amount the employer uses a formula to first calculate how much money is going to be contributed in total to all employees, then that “pot” of money is divided up to all employees in a method where higher earners gets a larger amount than lower earners

SEP IRA Income Limits

The only income limit that applies is the maximum income allowed combined with the maximum 25% contribution percentage. You can't receive more than $52,000 in contributions ($208,000 x 25%).

Income means different things for different employers. A SEP IRA can be used by a self-employed individual, a partnership, or a corporation with employees. Self-employed individuals and partnerships don't have W-2 income.

Here is what income is being measured for the purposes of the contribution with a SEP IRA:

  • Self-employed sole proprietors: Schedule C income
  • Partnership: Schedule K-1 income
  • Employee of corporation: W-2 wages

Any employee's compensation in excess of $260,000 for 2014 (and an amount above that tied to inflation for future years) may not be used in consideration of making a SEP IRA contribution.

SEP IRA Fees

One of the most attractive features of a SEP Plan and SEP IRAs are the fees associated with them. Many brokerage firms charge no account setup or maintenance fees for SEP IRAs. (Standard investment fees apply based on the investments elected by the employee.)

Compared to 401k plans this is a welcome sight. No complicated forms, no account administration company (and associated fees). Cut and dry, simple to administer, and free to provide employees. What's not to love?

SEP IRA Calculator

Benefits of a SEP IRA

Here are some of the key benefits for employers that use a SEP Plan:

  • Contributions are discretionary each year. Just because the employer contributed 12% last year doesn't mean they have to contribute anything this year. They could change to 25%, 0%, or anything in-between. 
  • Low fees. Employers can form a SEP Plan with very low, if not free of, fees.
  • Easy setup. Setting up a SEP IRA is easy. The IRS even provides Form 5305-SEP as a guide for employers; the form is not required (and in some cases may not be allowed) but usually can be used for setup.

The obvious benefit for employees: free retirement contributions that don't require you to contribute a dime. (You can, however, contribute up to the regular maximum within the Traditional IRA as you normally would.)

How to Open a SEP IRA

Opening a SEP IRA starts with actions by the employer:

  1. Form an agreement to use a SEP for all employees.
  2. Inform employees of SEP plan. (Often using Form 5305-SEP and providing employees a copy is enough.)
  3. Verify all eligible employees open a SEP IRA. Failure to have every eligible employee participating in the SEP plan can result in the IRS disqualifying the plan entirely.

From the employee side, it's pretty simple:

  1. Identify a brokerage firm that will allow you to open a SEP IRA.
  2. Open the SEP IRA. Typically this involves a basic account opening process where you provide personal information, get some forms to provide the employer so they can contribute into the account, and (if allowed) set up your bank account so you may contribute to the Traditional IRA portion of the SEP IRA.

Conclusion

SEP IRA's are a great retirement instrument for individuals whom are self-employed or an entrepreneur. As you can see they offer many great benefits and are very easy to setup.

However, as an entrepreneur myself I would actually recommend a self-directed IRA as it gives you more control over your retirement savings and diversification that you need by placing precious metals, real estate, and even your own business inside of the account. To find out more about them and why I personally choose this vehicle, click here to read more.

About the author 

Tom

Tom is a former accountant turned entrepreneur. He is not a financial adviser but does tend to give a lot of financial advice to his friends and colleagues. He currently runs a small online venture and blogs about his research and experiences.

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