Everyone is going to have to retire some day. Sure, some of us continue working past the standard retirement age of 65. In fact, these days, with life expectancy longer than it’s ever been, many more people are working all the way into their seventies, some even into their eighties. But if you have worked hard all your life, if you are actually looking forward to your retirement and have planned well for it too, then you’ve probably set up your own IRA or you even have some sort of retirement plan at your job like a 401K or a pension fund.
There are all types of retirement funds available. Besides the standard personal IRA, retirement plans at the workplace include the well known 401K, the 403B, even the government-sponsored 457. But did you know about the SEP IRA? The SEP IRA is a variation on the traditional IRA, and even though not as well known as its counterparts, still a very popular choice among those who seek an IRA for themselves in their employment. We will get into the details of the SEP IRA rules, but first let’s go over quickly exactly what an IRA is.
The SEP IRA — What is it?
The SEP IRA, the lesser know cousin to the popular Roth and traditional IRAs, stands for Simplified Employee Pension Individual Retirement Account. It is a variation on the Roth and traditional IRA. SEP IRAs, unlike the Roth IRA and the traditional IRA, are set up by business owners for themselves and their employees. This is also very popular with the small businessman known as the self-employed businessman. Someone working for themselves, or self-employed, isn’t normally thought of as a business owner with employees, but he is. The self-employed business owner has himself as an employee. Of course this sounds like some sort of technicality, but it does permit the self-employed person to qualify for a SEP IRA. The reason this is popular is that the administrative costs are very low, especially if that self-employed person has no employees. Now, under the SEP plan, if the self-employed person does indeed have employees, even just two or three, then the SEP IRA rules dictate that all the employees, including the business owner, must have the same plan. Eligibility requirements for the SEP are simple and pretty straightforward:
1. The self-employed person or his employees must be at least 21 years of age.
2. The employed person must have worked for this particular employer for at least three of the previous five years –These can be consecutive years or they can be non-consecutive. They must just meet the criteria of three years in five.
3. In that year that they are to qualify for the SEP IRA, they must have received at least $500 in compensation in that same tax year.
SEP IRA contributions are taxed at the normal income rate when accessed at the minimum age of 59.5 by retirees. This of course is the same rule as with the traditional IRA. Contributions to the SEP IRA are more along the line of the traditional IRA, being that the tax deduction comes on the front end and taxes are applied when the retiree withdraws funds.
The SEP IRA Rules and Contribution Limits
SEP IRA rules operate as if considered like they are a profit-sharing plan. This is because they come from the place of employment. There are limits on how much can be contributed to the fund, just like with the Roth IRA and the traditional IRA. The employer is allowed to contribute up to 25% of your wages into your SEP IRA every year. For example, if you make $60,000 a year then your employer can contribute up to a maximum of $15,000 into your SEP IRA account. This of course can be done once a year, every year while you are employed by the same employer.
There are financial limits as well as percentages as proportional to income. The maximum SEP IRA rules contribution is $49,000 in any one given year, and can be capped at $245,000.
For the self-employed these limits are a bit more complicated. The limit is approximately 18.6% of that person or company’s net profit. The actual computation itself is in IRS Publication 560.
Who uses the SEP IRA?
Large companies and even small businesses with multiple employees, for the most part, do not use the SEP IRA. Companies with multiple employees usually prefer the 401K or the 403B, or if they are a government organization they may use the 457. For the most part, those who like the SEP IRA are the self-employed.
How much you can contribute to your SEP IRA as a self-employed person depends on whether or not your business is a company, like a corporation, or whether you are in fact a sole proprietorship. A sole proprietorship is just a fancy way of saying it’s just you. It’s very much the same as personal income. It’s just a business owner who receives his compensation the same as personal income.
The SEP IRA vs. the 401K
Both the SEP IRAand the 401K are the most popular retirement account choices today. They are the most common on the market and the most widespread. Both have high contribution limits and flexible contributions. While a 401K may have more administrative capacity than an SEP, it may also allow greater annual contributions. One other issue may be that of borrowing against your retirement fund. Borrowing against your retirement fund is not allowed in the case of the SEP, while with the 401K you may be eligible to borrow up to half the funds value or up to a maximum of $50,000. But the advantage of the SEP, and this is why it is so popular with the self-employed, those who work by themselves and also call themselves a sole-proprietorship, is that the rules and administrating the fund are very simple. The 401K by contrast is more complicated. So if you are self-employed and it is just you, you may want to think: do you really want to be spending more time administering your 401K, or do you want to be spending more time making money and putting it into a SEP IRA?
So basically, breaking down the differences so you can see which would really be better for you, with the 401K the advantages are that the 401K allows for potentially greater contribution limits. We say potentially because you have to earn the money first to contribute it. Sure the limits are higher, but if you don’t even have the money, limits are obsolete. Still, with higher contributions come greater tax benefits. The 401K also allows you the option of taking a tax free loan against it, while the SEP does not.
Again, with the 401K the administration responsibilities are much greater. The 401K is more complicated and you will be spending more time playing with the rules and figures and less time doing what your business is supposed to be doing, and that’s earning money. If you just don’t like crunching all those numbers and learning all those rules and regulations, then the SEP IRA is better suited for you. The SEP IRA is a great plan and you can still contribute sufficient sums of money for your retirement. If the situation is right, the SEP IRA rules!