SEP IRA and How It Works
In a sense, a SEP IRA functions as a hybrid of a traditional IRA and a 401(k). The money you invest in the account is tax-deductible, and employer contributions can be vested immediately.
Here are some essential details you need to keep in mind while investing in SEP IRAs:
If you're already considering a SEP-IRA plan, keep scrolling because there is more information for you to peruse!
Who can Contribute to a SEP IRA
Any employer, from self-employed to a corporation, can set up a SEP-IRA plan for their employees. According to IRS standards, employees who qualify under the following criteria can participate:
- At least 21 years old
- Has worked under the employer for at least 3 years out of the last 5 years
- Has earned at least $650 (compensation requirement for 2021-2022) from the employer during the year
Note: Employees covered by a union agreement and those that are nonresident-aliens can not be included in SEP-IRAs.
How So I Set Up a SEP IRA
Setting up a SEP IRA is relatively simple. There are only several steps you need to complete:
- Choose a provider who will hold your SEP IRA.
- Formalize your agreement to open a SEP-IRA. You can do this by completing the IRS Form 5305-SEP or signing the IRS-approved prototype SEP provided by your chosen provider or financial institution. Another alternative is to complete an individually designed SEP plan.
- Provide information about SEP to eligible employees. You can give them a copy of FORM 5305 or obtain similar information from your provider.
- Work with your account provider to set up separate SEP-IRAs for each qualified employee.
How much Can I Contribute to SEP IRA
The contributions you make for each participating employee should be:
- Strictly based on the first $305,000 of compensation.
- Proportional to your employees’ compensation.
- Limited to the lesser of 25% of employee compensation or $61,000 (subject to annual cost-of-living adjustments for subsequent years).
Note: Above information below is updated for the year 2022.
If you’re self-employed, your contribution is your net earnings less one-half of your tax less your contributions to your SEP-IRA plan. You can browse IRS’ Publication 560 for more details here.Note: You are not required to contribute every year. In years that you do contribute, it must be made to all eligible employees. Moreover, it must be made in cash; properties are not allowed. If you mistakenly made more contributions than the annual limits, here’s how you can correct this mistake.
Pros and Cons of SEP IRA
A SEP-IRA provides features that can benefit those who want to invest large amounts in their retirement savings. We’ve listed the pros and cons of a SEP-IRA to help you make an informed decision based on your specific needs.
Pros of Investing in SEP-IRA
Ease of Setting Up
You can establish a SEP-IRA in just a few steps. See our guide above.
High Contribution Limit
You can contribute up to the lesser of 25% of compensation or $61,000. A few thousand higher than traditional and Roth IRAs, which is limited to $6,000 or $7,000 (if you're over 50 years old).
You are not required to contribute annually. You can do it at your own discretion as long as you contribute to all qualified employees.
You do not have to pay taxes on the money you contribute today. This includes contributions made to employee accounts.
You can deduct the lesser of your contributions or 25% of your compensation from your gross income (subject to the compensation cap: e.g., $305,000 for 2022 and $290,000 for 2021). Also, if you're self-employed, the deduction is 25% of your net earnings.
Cons of Investing in SEP-IRA
No Catch-up Provisions Offered
Some retirement savings plans like SIMPLE and traditional IRAs allow investors aged 50 or older to make additional contributions. You don’t have this option with SEP-IRAs.
Required Minimum Distributions
You must take mandatory withdrawals once you reach 72 years old. Because any withdrawal on your account entails taxes, some investors feel they are being penalized, especially if they don’t need or want the money.
Early Withdrawal Penalty
Contributions must be proportional
Proportional contributions must be made to each qualified employee if you contribute for yourself.
No Roth Option
You cannot choose to make contributions with after-tax money. There is no option in SEP-IRA that will allow you to pay taxes now and take withdrawals tax-free in the future, unlike with Roth IRAs.
SEP IRA vs. SIMPLE IRA
If you’re still new to investing in IRAs, it’s no surprise to be confused between SEP and SIMPLE IRAs. For your convenience, we’ve listed some of the main distinctions below:
Self-employed individuals to corporations
Small business with 100 or fewer employees
Employer and employees
Account Holder Qualifications
Must be at least 21 years old, employed for at least 3 years out of 5, and earned a compensation income of at least $650.
The employee must have earned at least $5,000 within two years, whether consecutive or not, and are expected to make as much during the calendar year.
25% of employee’s compensation or $61,000, whichever is lower.
$14,000 for those under 50 and a maximum catch-up contribution of $3,000 for those beyond 50 years.
Can I Withdraw Money From My SEP IRA?
Yes, you can withdraw money from your SEP IRA at any time, but there are some restrictions. Your withdrawal may not be deductible in your taxable income and may incur a 10% additional tax if you have not reached the age of 59 1/2. There are, however, some exceptions to this rule. Here are some:
If you can no longer work due to a permanent disability, the IRS will allow you to withdraw money without incurring the 10% penalty. You can use the funds for any purpose as long as you provide proof of your disability to your plan administrator.
If you’re not covered by health insurance and have out-of-pocket medical expenses, you can get penalty-free distribution to pay for these. Note that it must be paid the same calendar year you requested the withdrawal. Moreover, your unreimbursed medical expenses must exceed your 2022 adjusted gross income by about 10%.
To Illustrate: If your income is $200,000 and the unpaid expenses totals $25,000, then the penalty-free distribution will only cover $5,000 (e.g. $25,000 less the 10% of $200,000).
This generally covers tuition, books, supplies, equipment, and other fees required for enrollment. For students enrolled at least half-time, room and board are also included.
You can withdraw a maximum of $10,000 without penalty as long as the money is used to buy, build, or rebuild a house. The condition is you must be a “first-time” homebuyer and haven’t owned a home for the past two years.
If you want to learn more about the withdrawal rules and their exceptions, check out the
The advantage of saving pre-tax money for retirement and offering benefit plans for your employees can be appealing. SEP-IRAs allow small business owners and self-employed individuals like yourself to establish a retirement plan quickly.
Still, there are a few drawbacks to investing in one. Its inability to allow employees to make contributions and the requirement for business owners to contribute the proportional percentage for all qualified employees might be worth pondering.
If you have anything you’re still not sure of, contact us to get more information about setting up a SEP IRA or investing in one.
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