The SEP IRA is a retirement plan designed to benefit self employed individuals and small business owners, Sole proprietorship, S and C corporations, partnerships and LLCs qualify.
In 2017, a SEP IRA has a contribution limit of $54,000. Contributions to a SEP IRA are generally 100% tax deductible and investment earnings in a SEP IRA grow taxed deferred. Withdrawals after age 59 1/2 are taxed as ordinary income. Withdrawals prior to age 59 1/2 may incur a 10% IRS penalty as well as income taxes.
A SEP IRA has broad appeal due to its high annual contribution limits, completely discretionary and flexible annual contributions and minimal administration. SEP IRA plans can be established by a one person business or by a business owner with employees.
Most frequently a SEP IRA is established by a business owner without employees and is discussed in detail below.
In special situations a SEP IRA may be an ideal retirement plan for a business owner with employees.
SEP IRA for a self employed business owner without employees
The calculation of how much can be contributed to a SEP IRA is dependent on whether your business is a corporation and you receive a W-2 as compensation or if you are taxed as a sole proprietorship and receive compensation as personal income. Examples of both are shown below.
1) Business owner receives compensation as W-2 income:
An S or C corporation, an incorporated partnership or a LLC electing to be taxed as a corporation pays the business owner a W-2 salary. In this situation, the annual SEP IRA contribution can be between 0% to 25% of the owner's W-2 salary up to the SEP IRA contribution limit. SEP IRA contributions are generally 100% tax deductible as a business expense.
2) Business owner receives compensation as personal income
When a SEP IRA is established for a unincorporated business such as a sole proprietorship, unincorporated partnership or a LLC electing to be taxed as a sole proprietorship, annual contributions are made into your SEP IRA account between 0 to 20% of your net adjusted self employment income (or net adjusted business profits). SEP contributions are flexible and the percentage of contribution can be changed at any time and may be skipped in a bad year. SEP IRA contributions are generally 100% tax deductible from personal income.
Net adjusted self employment income is calculated by taking gross self employment income and then subtracting business expenses and then subtracting 1/2 of the self employment tax. An annual SEP IRA contribution can be made between 0% to 20% of that figure up to the annual SEP IRA contribution limit.
SEP IRA contributions are flexible and the percentage of contribution can be changed at any time. SEP IRA contributions are generally 100% tax deductible from personal income.
Generally a SEP must be established and funded by your tax filing deadline. Normally, filing extensions extends the period for establishing and funding the SEP plan. For a sole proprietor, April 15th would be the deadline to establish and fund a SEP for the prior tax year. If an extension was filed a sole proprietor can establish and fund a SEP IRA by October 15th.
A self employed business owner with no full time employees other than a spouse may also want to consider an Individual 401k as well as a SEP IRA.
A SEP IRA allows a contribution of up to 20% of net self employment income or 25% of W-2 wages, but an Individual 401k frequently permits a larger contribution at the same income level and may allow a greater contribution.
Another feature of an Individual 401k versus a SEP IRA is an Individual 401k permits a loan up to 1/2 the value of the account up to a maximum of $50,000
Selecting the right retirement plan can be confusing and the subtle differences between options can sometimes be overlooked.
If you are a self employed individual or an owner and spouse business and are considering a SEP IRA or Individual 401k reading this information should help you make your decision easier by explaining the differences.
The SEP IRA and Individual 401k are the two most common retirement plans chosen by successful self employed individuals and owner and spouse businesses due to their high contribution limits and flexible annual contributions. Individual 401k plans have greater administrative responsibilities than a SEP, but may allow a larger annual contribution at identical income levels due to the way the annual contribution is calculated.
Another issue to consider is whether you’d like to have the option of borrowing against your retirement plan by using your retirement plan's balance as collateral and receive an Individual 401k loan. IRS rules do not permit a loan in a SEP IRA, but an Individual 401k loan of up to half of the plan's value up to a $50,000 maximum is allowed.
This a a brief comparison of these self-employed retirement plans.
Features- For 2017, there is $54,000 maximum contribution
Advantages- Easy to setup and low administrative responsibilities.
Disadvantages- An Individual 401k may provide a larger contribution and tax deduction compared to a SEP IRA. For those age 50+ there isn't an additional $5500 catch-up contribution provision like there is with the Individual 401k.
Who would be appropriate for a SEP IRA?
Simply, the SEP IRA is a great choice for self employed individuals or owner and spouse businesses who would like to contribute up to 25% of their W-2 earnings or 20% of net self employment income up to the SEP IRA contribution limit. A SEP provides high maximum contribution limits, but an Individual 401k may allow a greater contribution at the same income level.
A final point to consider is IRS rules do not permit loans with a SEP IRA. A SEP IRA is the right choice if you aren't in need of a loan and don't anticipate needing one in the future.
It is important to note that you can set up a SEP IRA and convert to an Individual 401k in the future if you change your mind and either want to receive an Individual 401k loan or if you want to contribute more than the calculations of a SEP IRA will allow. Converting from a SEP IRA to an Individual 401k and transferring retirement assets from a SEP IRA to a new Individual 401k can be accomplished by completing some minor administrative paper work.
If this sounds like you then keep it simple and set up a SEP IRA.
Features- For 2017, there is $54,000 maximum contribution ($60,000 if age 50+ due to a "catch-up" provision). Loans are permitted in an Individual 401k.
Advantages- Potentially greater retirement contributions at identical income levels compared to a SEP IRA. Individual 401k loans are permitted up to 50% of the total 401k value with a $50,000 maximum.
Disadvantages- Potentially greater administrative responsibilities and administrative fees compared to a SEP IRA.
Who would be appropriate for an Individual 401k?
The Individual 401k and the SEP IRA have comparable maximum limits, but due to the way the contribution is calculated a self employed individual may be able to contribute more into an Individual 401k versus a SEP IRA at the same income level, therefore maximizing retirement contributions and valuable tax deductions.
Here's how the calculation works. As of 2017, participants in an Individual 401k can contribute up to 100% of the first $18,000 ($24,000 if age 50+) of W-2 compensation or net self employment income for a sole proprietorship. In addition, a profit sharing contribution can be made up to 25% of W-2 wages or 20% of net self employment income. The contribution limit calculation in an Individual 401k is important because it allows you to potentially save more than a SEP IRA at the same income level.
Another important distinction between the SEP IRA versus the Individual 401k is the loan feature. An Individual 401k loan may be considered a valuable feature to some self employed business owners.
For many successful business owners the decision of which retirement plan to choose comes down to either a SEP IRA or Individual 401k. Simply stated there are 2 primary advantages of the Individual 401k over the SEP IRA:
If you value the loan feature or want to maximize your annual retirement contributions then you should consider an Individual 401k. If not, the simplicity of a SEP IRA makes it the best choice for you.
A SEP IRA plan can be established by a business owner with employees. A SEP IRA is funded 100% by the employer, employees do not contribute.
When a SEP IRA is established each eligible employee would open their own separate SEP IRA account. Annually the employer would make a contribution to their own SEP IRA account and to each eligible employee's SEP IRA account. The percentage contributed into each SEP IRA account is the same percentage for the employer and each eligible employee. The annual contribution percentage made by the employer is flexible and can be changed from year to year depending on profitability.
In general, contributions to the owner's SEP IRA account and the contributions made to each eligible employee's SEP IRA account are 100% tax deductible as a business expense. A SEP IRA allows generous contribution limits but also requires generous contributions from the employer on behalf of all eligible employees.
Who is considered to be an eligible employee?
Generally, when a SEP is established IRS Form 5305 is completed. This short form sets the eligibility requirements for determining who is eligible such as age and length of employment. This form should be kept on file by the employer. When the employer and employees meet the eligibility requirements stated on the completed 5305 form then the employer must make contributions on their behalf. Employers must satisfy the same requirements as the employees. Employers can make the eligibility requirements less strict, but must make contributions to employees if they meet the following 3 requirements:
SEP IRA Eligibility
Incorporated and unincorporated businesses. Sole proprietors, partnerships, LLCs, Subchapter S and C corporations qualify.
Must part time and seasonal employees be included in the SEP IRA?
Yes, if they earned $450 or more in the current year and worked for the business in 3 of the past 5 years and they are age 21 or older. Non resident aliens may be excluded. When a SEP IRA is established a short form called IRS Form 5305 is completed which states the eligibility requirements. The requirements can be less restrictive than the above stipulations, but can't be more restrictive.
In what situations might a SEP IRA be appropriate?
A SEP IRA may be a good option for employers who want to make high contributions to their own SEP account and the SEP accounts of partners or employees.
Why would an employer with employees choose the SEP IRA?
An employer might choose the SEP IRA to be generous to employees and create loyalty and lower turnover. It also might serve as a motivating factor for employees because annual contributions are flexible at the employers option. For example an employer might elect to contribute to a SEP IRA only if a certain threshold of sales or profits is reached. Because the employer contribution can be from 0 to 25% of employees wages, the employer can adjust that percentage annually depending on company sales or profits at their discretion.
Is the SEP IRA a good retirement plan option for a family business employing their children?
Yes. The SEP IRA is very egalitarian and requires that contributions for employees be at the same percentage of income as for the business owner. SEP IRA contributions are made by the employer and the contributions are vested immediately. Therefore it is a generous retirement plan and employee benefit, but expensive for employers. However, when the employees are the children the money stays in the family and the parents are helping their children prepare for retirement and the contribution is a tax deductible business expense.
I am a business owner and my spouse is the only employee. Is the SEP IRA our best option?
Maybe. It depends on how much you wish to contribute. A SEP IRA and an Individual 401k should be considered. An Individual 401k may allow a greater contribution than a SEP IRA due to the way the contribution is calculated. Also, loans are permitted with an Individual 401k.