Saving for retirement with a SEP IRA

WHAT IS A SEP IRA?

A Simplified Employee Pension Individual Retirement Arrangement is a tax-deferred retirement savings plan designed specifically for small-business owners and the self-employed. This type of SEP plan allows employers to make contributions to individual retirement plan accounts on behalf of their employees and, in turn, they receive a tax deduction for the amount contributed. Unlike traditional 401k plans, SEP IRAs are often simpler and less costly to administer, making them an attractive option for businesses with few employees.

With a SEP IRA plan, employer contributions are flexible, allowing business owners to decide how much to contribute each year, which can be especially beneficial in years of fluctuating net profits. This flexibility in employer contributions makes SEP IRAs a popular choice among small businesses looking to provide retirement benefits without the complexity of other plans.

So, is a SEP IRA the right retirement plan for you and your business? 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; instead, these accounts are funded solely by employer contributions using tax-deductible dollars.

With the SEP IRA, while the employee doesn’t get to deduct the contributions, the business does, effectively lowering its taxable income. However, the employee will pay taxes on the distributions during retirement, similar to traditional IRA distributions.

Most sole proprietorships, S-corporations and partnerships – or pass-through entities – are owned by individuals. By lowering their business income through SEP contributions, their individual tax liabilities are also decreased. This tax deduction can significantly benefit small-business owners by reducing income tax liabilities and helping their employees optimize their retirement savings.

SEP IRA CONTRIBUTION LIMITS

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

• Generous contribution limits. Employers may contribute up to 25% of each employee’s annual compensation. This is a generous percentage, but the maximum dollar amount for contributions is capped at $69,000 for the 2024 tax year and $70,000 for 2025.
• Comparison with other IRAs. Both traditional and Roth IRAs have income limits for both contributions and deductions. For 2024 and 2025, traditional IRAs and Roth IRAs have a $7,000 annual contribution limit, or $8,000 if you’re more than 50 years of age. Unlike traditional IRA contributions, SEP IRA limits are substantially higher, allowing for greater retirement savings.
• Self-employed contributions. Self-employed individuals may contribute up to approximately 25% of their net self-employment earnings, or adjusted earned income, to their own SEP account.

Because contributions are tax-deductible, as a business owner, you can likely take a tax deduction 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 account. Since SEP IRA contributions are based on net income and can vary based on your business structure, talk with your tax professional to understand the best way to proceed.

It's important to note that there are no catch-up contributions for those over age 50 with SEP IRAs, unlike traditional and Roth IRA contributions, which allow for additional contributions. Also, all employer contributions vest immediately, meaning employees have full ownership of the funds as soon as they are deposited into their IRA accounts.

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 Internal Revenue Service has a model plan (Form 5305-SEP) you can adopt to simplify the process. This form outlines the terms of the SEP plan and helps ensure compliance with IRS regulations. 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, based on a uniform contribution rate. This includes any eligible employee over 21 who has worked for you in at least three of the last five years and received at least $750 in compensation during the year.
• Choose a financial institution. This can be a bank that offers traditional IRAs or any other IRS-approved IRA trustee or custodian. Be sure to consider the investment options available, such as stocks, bonds, mutual funds or self-directed IRAs, to find the best fit for your employees' retirement accounts.
• Create accounts. Set up separate SEP IRA accounts for each eligible employee and transfer funds into these accounts for all participants. Each employee will manage their own SEP IRA account, including investment decisions and distributions upon retirement.

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:

• Tax-deductible contributions. 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 income tax owed to the IRS. This tax deduction can be a significant benefit for your business's bottom line.
• High contribution limits. You can make very large contributions. The IRS allows you to contribute up to approximately 25% of net income – up to $69,000 in the 2024 tax year or $70,000 in 2025 – whichever is less per year. This is significantly higher than the limits for traditional or Roth IRA contributions.
• Time flexibility. 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. This flexibility can be advantageous for businesses needing more time to assess their financial situation.
• Ease of administration. SEP IRAs are generally inexpensive and easy for small businesses with few employees to manage since there aren’t many rules governing them. They don’t require filing any annual returns with the IRS, reducing administrative burdens and costs.

CONS:

• Not ideal for maximizing personal contributions. It’s not for everyone. For self-employed individuals looking to save more than $70,000 annually, a solo 401k or other retirement plan might be a better option.
• No catch-up contributions. 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. This could limit retirement savings for older individuals seeking to maximize their contributions.
• No employee salary deferrals. Employees cannot make salary deferral contributions, such as those allowed in a SIMPLE IRA or a 401k plan. All contributions are made by the employer, which may not satisfy employees looking to contribute more to their retirement accounts.
• Immediate vesting. Employee contributions vest immediately. While 401k employer matching can include a vesting schedule, contributions to a SEP IRA are immediately 100% vested. This means employees have full ownership of the funds right away, which might not encourage long-term retention.

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. However, it's essential to compare it with other retirement plans like the SIMPLE IRA, traditional IRA, Roth IRA, and solo 401k to determine the best fit for your situation.

By setting up a SEP IRA plan, you are taking a significant step toward securing your retirement and offering valuable benefits to your employees. Not only does this provide a retirement savings vehicle, but the employer contributions are also a tax deduction for your business, reducing your taxable income.

Be sure to talk with your financial advisor and your tax advisor before deciding which plan is right for your retirement savings goals. They can provide guidance on how the Secure Act and other recent legislation might impact your retirement planning, and help you navigate issues like required minimum distributions, excess contributions and the contribution deadline.