SEP IRA written on a jar of money on a table with books and glasses

A Basic Guide to the SEP IRA

A SEP IRA can be a smart retirement plan option if you want higher contribution limits, flexibility, and tax advantages. Here’s how they work.

Key takeaways:

  • SEP IRAs are flexible retirement savings options, especially helpful to business owners with few or no employees
  • SEP IRAs have high contribution limits: $58,000 for 2021
  • Only employers can contribute to employees’ SEP IRAs
  • Business owners can change contribution amounts each year, but percentages must be the same for themselves and all their employees
  • Tax advantages include tax-deferred investments and contribution deductions

Self-employed workers and business owners often must establish a more involved tax planning strategy to maximize credits and deductions and comply with all IRS requirements. It can be challenging to find the right retirement option that will help you contribute enough each year and lower your tax burden. 

The simplified employee pension (SEP IRA) could be the right option. Let’s cover how this plan works, who qualifies, and the key tax advantages.

What is a SEP IRA?

The SEP IRA is an individual retirement account that business owners and self-employed workers can create. Employers decide how much to contribute to each employee’s plan, and they can take advantage of a tax deduction for these contributions. For employees, any contributions their employer makes to their SEP IRA are 100% vested right away, which is a big benefit for them as well.

Many business owners decide to go with the SEP IRA because these accounts have high annual contribution limits. Contributions can’t be higher than the lesser of 25% of a worker’s compensation or $58,000 in 2021. Compare these amounts to traditional IRA limits, which are $6,000 for 2021 or $7,000 for those 50 and older.

Unlike other employer-sponsored retirement plans, the SEP IRA doesn’t require certain startup and operating costs, as administrative expenses are low. 

This is also an attractive option because employers can take a break from making contributions if the business is going through a rough patch. Each year, the employer can decide how much or whether they want to contribute. They can lower and raise contributions amounts year-over-year as needed. This flexibility helps smaller business owners offer a retirement savings option without being locked in each year.

Essential eligibility requirements for SEP IRA participants are as follows:

  • They are at least 21 years old
  • They have worked for the employer for at least three years of the last five years
  • They earned at least $600 in compensation in the previous year

An employer must provide access to the SEP IRA if a worker meets these requirements. But individual employers may opt to use “less restrictive requirements, for example age 18 or three months of service, to determine which employees are eligible.” In all cases, the employee owns and controls their account and can make decisions about retirement investments.

A critical note about SEP IRAs is that if you contribute for yourself as the business owner, you’re required to have proportional contributions for each of your eligible employees. In other words, the contribution rate must be the same for you and all of your workers. So, the SEP IRA is usually best for business owners who have few or no employees.

Other facts about SEP IRAs:

  • There isn’t a catch-up contribution for people age 50 or over, as with traditional IRAs.
  • Minimum distributions are required starting at age 72.
  • Early withdrawals before age 59 ½ are subject to a penalty of 10% and are taxed as income.
  • The SEP IRA may be combined with a Roth or traditional IRA.
  • Employees cannot make contributions—only employers.

SEP IRAs are easy to set up and manage, so they’re great options for small business owners and self-employed workers looking for a more flexible retirement savings alternative. The SEP IRA is available to businesses of any size.

SEP IRAs and taxes

As with traditional IRAs, investments within each employee’s SEP IRA grow tax-deferred until they retire, and withdrawals are then taxed as regular income. Contributions and earnings to SEP IRAs can be rolled over tax-free to other retirement plans and IRAs.

There’s not a Roth option for SEP IRAs, in which contributions are taxed now instead of in retirement. However, as mentioned above, a SEP IRA can be combined with a Roth IRA if desired. 

When tax time rolls around, you can deduct the lesser of your SEP IRA contributions or 25% of compensation, though there is a limit on compensation: $290,000 in 2021. For self-employed workers, the deduction amount is 25% of net income.

In sum, SEP IRAs provide: 

  • A low-administrative-cost retirement savings option
  • Several tax advantages, including tax-deferred investments and contribution deductions 
  • Flexibility that is especially helpful to small business owners who want the ability to decide how much to contribute each year

Where to turn with questions

Choosing the right retirement savings strategy for your business can be a big part of your overall growth plan. You always need to understand tax implications and the pros and cons for both you and your employees. 

When you have questions about the best tax planning and business growth approach, contact the team at Provident CPA and Business Advisors. We help you establish the best tax-advantaged strategies that put your business on the right path for a successful future,

Contact us to learn more about our services.

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