SEP IRA Rules
What is a SEP IRA?
The SEP IRA or Simplified Employee Pension Individual Retirement Arrangement is a type of Individual Retirement Account (IRA). Employers and business owners offer this as a benefit for the retirement planning of employees, but this plan is used most commonly by self-employed persons with no employees. The funds can be invested just like in any other IRA, that is, in stocks, bonds, mutual funds, money market funds, savings accounts and other investment vehicles.
These plans are attractive because of the high annual contribution limits, flexibility and minimal administration requirements. Contributions to the plans can be deducted from your taxes and the earnings in a SEP IRA are tax deferred.
When compared to an individual 401(k), the SEP IRA has less administration requirements, but the 401(k) may allow for a larger annual contribution. Also you can take loans against an individual 401(k) but not against a SEP IRA. If your needs change you can also convert your SEP IRA into a 401(k) in the future.
Who qualifies for a SEP IRA?
Eligibility requirements can be largely left up to the employer but can not be stricter than the following. The participant:
- must be at least 21 years old
- must have performed work for the employer during a minimum of three of the last five years, and
- must have been paid at least $500 in compensation for the fiscal tax year
What are SEP IRA plan rules?
The contribution limit as of 2012 is $50,000 per year. One must remember that the SEP IRA withdrawals are taxed at ordinary income tax rates when funds are taken after 59 ½ year of age. If withdrawals are made before this time you may have to pay a 10% IRS penalty on top of regular income taxes.
When calculating how much the self-employed without employees can add to their SEP IRA, there are two situations to consider, each with different restrictions.
Scenario 1: the business exists as a corporation and gives you a W-2.
Scenario 2: you receive your pay as personal income, that is, you have sole proprietorship tax status.
In the first case (you receive a W-2), 0-25% of the owner’s W-2 salary but not greater than the SEP IRA limit is allowed as an annual contribution. In the second case (sole proprietorship), 0-20% of your self employment income (net adjusted) is allowed as your annual contribution limit. Contributions are not necessarily fixed and amounts can be changed within the accepted parameters for any tax year.
You must keep into account deadlines, for example, the account must be set up and funded by the tax filing due date.
Overall the SEP IRA is a great option for self employed persons as it allows up to 25% of their earnings (W-2) or 20% of net self-employment income to be contributed up to the limit per year. The SEP IRA is also attractive because of its minimal administrative requirements.