What Is a SEP IRA? How SEP IRAs Work
As seen in NerdWallet on November 16, 2020
A SEP IRA reads like a mess of letters, and spelling it out doesn’t necessarily help: The first part stands for simplified employee pension; the second for individual retirement account.
Translation: It’s a retirement account that offers tax breaks for business owners and self-employed individuals who put money away for the future.
What is a SEP IRA?
A SEP IRA is a basic individual retirement account, much like a traditional IRA. SEP IRAs are for business owners, and contributions are tax-deductible. Investments grow tax-deferred until retirement, when distributions are taxed as income.
Who is eligible for a SEP IRA?
Generally, SEP IRAs are best for self-employed people or small-business owners with few or no employees. Here's why: If you have employees whom the IRS considers eligible participants in your plan, you must contribute on their behalf, and those contributions must be an equal percentage of compensation to your own.
Eligible participants are employees who are 21 or older, have worked for you for three of the past five years and have earned at least $600 from you in the past year. For example, if an employee worked for you in 2017, 2018 and 2019, you would need to make a contribution for him or her for the 2020 plan year.
If you want to stash away 15% of your compensation for yourself, you must also contribute 15% of that employee's compensation to his or her plan.
Employees own and control their own accounts.
Because of that rule requiring equal contributions as a percentage of compensation, a SEP IRA is generally best for self-employed people or small-business owners with few or no employees.
What are the SEP IRA contribution limits?
A traditional IRA allows you to put away $6,000 each year (that's the annual maximum in both 2020 and 2021; it's $7,000 if you’re 50 or older). With a SEP IRA, you can stockpile nearly 10 times that amount, or up to $57,000 in 2020 and up to $58,000 in 2021. However, SEP IRA annual contribution limits cannot exceed the lesser of:
25% of compensation
$57,000 in 2020 or $58,000 in 2021
The first limit, 25% of compensation, is also the limit for how much you can contribute for each eligible employee. The amount of compensation you can use to calculate the 25% limit is limited to $285,000 in 2020 and $290,000 in 2021.
There's no catch-up contribution at age 50+ for SEP IRAs.
You can combine a SEP IRA with a traditional or Roth IRA. If you’re an employee who is covered by a SEP IRA, employer contributions don’t reduce the amount you can contribute to an IRA for yourself, but the amount of your traditional IRA contribution that you can deduct may be reduced at certain higher income levels, due to the combination of both plans.
How does a SEP IRA work? The pros and cons
PROS
That high contribution limit of up to $57,000 in 2020 and $58,000 in 2021
Easy to set up and administer
Can be combined with a traditional IRA or a Roth IRA
Contributions are tax-deductible, including those made to employee accounts. You can deduct the lesser of your contributions or 25% of compensation, subject to the compensation cap ($285,000 in 2020; $290,000 in 2021). If you’re self-employed, your deduction is 25% of net self-employment income.
Flexibility: You don't have to commit to contributing every year
CONS
No catch-up contribution for savers 50 or older
No Roth version, which means you can't opt to pay taxes on contributions now and take distributions tax-free in retirement, as you can by choosing a Roth IRA
Required proportional contributions for each eligible employee if you contribute for yourself
Like traditional IRAs and 401(k)s, SEP IRAs require minimum distributions beginning at age 72
Also like a traditional IRA, distributions before age 59½ are taxed as income and subject to a 10% penalty, unless the reason for the distribution satisfies one of the early withdrawal exceptions
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