Saving for retirement with a SEP IRA

WHAT IS A SEP IRA?

Simplified Employee Pension plans are tax-deferred retirement savings plans designed for small-business owners and the self-employed. SEP IRAs are employer-sponsored, allowing business owners to make tax-deductible contributions to individual retirement accounts on behalf of their employees. For many small-business owners, SEP IRAs may be much easier and less costly than administering a traditional 401k. So, is it the right option for you? Let’s explore the basics to find out.

THE BASICS OF SEP IRA CONTRIBUTIONS AND DISTRIBUTIONS

Employees do not contribute directly to a SEP IRA. They are funded solely by the employer using tax-deductible dollars. Unlike other retirement plans, SEP plans don’t offer Roth or post-tax contributions. In general, if your income is under applicable thresholds, traditional IRAs and 401ks allow you to deduct contributions, but you pay taxes on distributions (including any earnings). That’s known as a tax-deferred plan. Roth IRAs and Roth 401ks don’t offer an upfront deduction, but distributions (and earnings) are tax-free. That’s known as a tax-exempt plan.

With the SEP IRA, the employee doesn’t get to deduct the contributions per se; the business does. But the employee will pay taxes on the distributions (similar to a traditional IRA).

Most sole proprietorships, S-corporations and partnerships, or pass-through entities, are owned by individuals. By lowering their business income, their individual tax liabilities are also decreased.

SEP IRA CONTRIBUTION LIMITS

When saving for retirement with a SEP IRA, contribution limits are as follows:

• Contributions may be up to 25% of each employee’s annual compensation. This is a generous percentage, but the maximum dollar amount for contributions is capped ($69,000 in 2024 tax year).
• For 2024, traditional IRAs/Roths have a $7,000 annual contribution limit, or $8,000 if you’re more than 50 years of age.
• Self-employed individuals may contribute up to approximately 20% of their net self-employment earnings to their own SEP account.

Because contributions are tax deductible, as a business owner, you can likely take a tax write-off by contributing to your SEP IRA up to the limit. This can be a great way to reduce your overall tax liability while building up your retirement savings. Since SEP IRA contributions are based on W-2s (employee compensation) and can vary based on your business structure, talk with your tax professional to understand the best way to proceed.

SETTING UP A SEP IRA

A SEP IRA follows a formal, written retirement plan set up by the employer. Setting up a SEP IRA is fairly easy, but here are some steps you should review with a qualified tax professional:

• Finalize the written plan. The IRS has a model plan you can adopt to simplify the process. Depending on where you choose to hold the funds for the SEP IRA, some financial institutions may have their own models as well.
• Decide on your business’s contribution. You’re not required to make contributions each year, but if you do, you must contribute to all eligible employees’ accounts equally.
• Choose a financial institution. This can be a bank that offers traditional IRAs or any other IRS-approved IRA trustee or custodian.
• Create accounts. Set up separate accounts for each eligible employee and transfer funds into these accounts for all participants.

Once you’ve followed these steps and established the plan with your chosen financial institution, you’ll need to prepare a few additional documents and either file them yourself or deliver them to your tax professional. For example, Form 5305-SEP is an instruction form from the IRS that has information on how much an employer can contribute to its employees’ SEPs based on compensation. It also provides information on applicable laws pertaining to these plans, such as minimum participation requirements and nondiscrimination rules.

THE PROS AND CONS OF SEP IRAS

Before deciding if a SEP IRA is right for you, let’s look at the pros and cons.

PROS:

• Your contributions to a SEP IRA are tax deductible. This means you can deduct your contributions from your business’s taxable income, effectively lowering the amount of taxes.
• You can make very large contributions. The IRS allows you to contribute up to approximately 25% of net income – $69,000 (in 2024 tax year), whichever is less per year.
• Time is on your side. You can set up and fund a SEP IRA right up until the day you file your business taxes (including an extension) and still gain the tax benefits. Alternatively, a 401k must be set up by Dec. 31 of the tax year.
• It’s easy to administer. SEP IRAs are generally inexpensive and easy for small businesses with few employees to manage since there aren’t many rules governing them and they don’t require filing any annual returns with the IRS.

CONS:

• It’s not for everyone. The solo 401k might be a better option if you’re looking to save more than $58,000 annually.
• Participants can’t catch up. Unlike a traditional IRA or 401k, SEP IRAs do not offer a catch-up provision for those age 50 and older.
• Employees can’t leverage a company match. A traditional 401k may be preferable for employees with an employer that offers matching contributions.
• Employee contributions vest immediately. While a 401k can include a vesting schedule, contributions to a SEP IRA are immediately 100% vested.

Ultimately, as a small-business owner, you may find the SEP IRA best suited to your needs due to the low administrative requirements and relatively higher contribution limits. Be sure to talk with your financial advisor and your tax professional before deciding which plan is right for your retirement savings goals.