What is a SEP IRA?
A SEP IRA is a retirement savings plan specially designed for small business owners and their employees. It allows them to put money aside for retirement. Just like regular IRAs, SEP IRAs are owned and managed by the person who has the account.
These retirement plans can be used by businesses of any size, but they work especially well for self-employed individuals or businesses with only a handful of workers. If an employer sets up a SEP IRA, they have to contribute 100% of the funds, and all eligible employees must receive the same benefits.
How does a SEP IRA work?
In a SEP IRA, it’s the business owner who puts money into their employees’ retirement accounts, not the employees themselves. The key thing to remember is that the percentage of contributions must be the same for everyone.
Let’s break it down: If an employer puts in 25% of their own yearly earnings into their SEP IRA, they need to do the same for each of their employees, making sure it’s also 25% of each employee’s salary.
Now, when it comes to the money in a SEP IRA, it’s owned and managed by each individual employee. These accounts follow the same rules as regular IRAs when it comes to investing, taking out money, and moving it around. The cool part is that any investments in a SEP IRA grow without getting taxed until you decide to take the money out.
But here’s the catch: When you retire and start withdrawing money from your SEP IRA, you’ve got to pay taxes on it, just like with a traditional IRA. And if you’re in a hurry and take money out before you’re 59 and a half, you’ll have to pay an extra 10% penalty on top of the regular taxes.
One more thing to keep in mind: Once you hit 72, you’ll need to start taking out a certain minimum amount from your SEP IRA every year. It’s just one of those things the IRS requires to make sure you don’t keep your money tucked away forever.
Investment Opportunities within SEP IRAs
When it comes to investing with SEP IRAs, you have quite a bit of flexibility. However, there are some rules to keep in mind.
First off, the IRS doesn’t allow you to invest in things like collectibles or life insurance with your SEP IRA. But honestly, those aren’t common choices for most investors anyway. Also, you can’t use your SEP IRA money to get into trading derivatives that have undefined or unlimited risks – that’s a no-go.
Now, the exact investment options you have depend on where you have your SEP IRA. Most places that hold these accounts, like brokerage firms, let you buy and sell a wide range of stuff. This includes stocks, bonds, exchange-traded funds (ETFs), mutual funds, money market funds, and certificates of deposit (CDs). Just keep in mind that some brokerages might put limits on certain types of trading, like options.
Who Qualifies for a SEP IRA
If you’re your own boss or you own a business, you can set up a SEP IRA for yourself. But if you’ve got employees, here’s what the IRS says about who can have one:
- They need to be at least 21 years old.
- They should have worked with your company for at least three out of the past five years.
- In 2023, they should earn at least $750 (in 2022, it was $650).
All your eligible employees should get their own SEP IRAs.
Now, you can make the rules a bit easier if you want, but whatever you decide should be the same for everyone in your company – owners and employees alike. If you ever want to change the rules, that’s okay, but they should be at least as strict as what the IRS says.
SEP IRA contribution limits
Well, there are two ways to figure it out, and you can go with the smaller of the two:
- 25% of your earnings if you’re the business owner or an employee.
- In 2022, it was $61,000, and in 2023, it’s $66,000.
Now, that’s quite a bit more than the regular $6,500 you can put into a standard IRA in 2023. And here’s another thing: Your employer can decide not to put money into your SEP IRA for a specific year, but they have to treat all owners and employees equally if they do that.
Combining a SEP IRA with other retirement accounts
Having a SEP IRA doesn’t mean you can’t have other retirement accounts too. However, since a SEP IRA is set up by your employer, there are some extra rules from the IRS when it comes to adding money to other retirement funds.
SEP IRAs and traditional IRAs: If you’re using a SEP IRA, you’re not out of the game for a traditional IRA. But here’s the catch: if your employer chips in for your SEP IRA and you make a pretty good income, you won’t get the full tax deduction for your traditional IRA. For the nitty-gritty, in 2022, this starts happening when your modified adjusted gross income hits $68,000 for individuals and $109,000 for married folks who file their taxes together. In 2023, these numbers go up a bit to $73,000 for single filers and $116,000 for those married and filing jointly. So, just keep that in mind when planning your contributions.
SEP IRAs and Roth IRAs: You can have both a SEP IRA and a Roth IRA. The good news is that the maximum amount you can put into a Roth IRA each year isn’t affected by having a SEP IRA or any other employer-sponsored plan.
SEP IRAs and 401(k)s: It’s pretty rare to have both a SEP IRA and a 401(k) from the same employer because there are limits on how much your employer can contribute to both types of accounts together. However, if you have two different jobs and each offers its own retirement plan, you can participate in both. So, you could have a SEP IRA at one job and a 401(k) at the other.
SEP IRAs and HSAs: If you want to save for retirement with a SEP IRA and also set money aside for healthcare expenses in a health savings account (HSA), you can do that too. Your SEP IRA contributions won’t mess with your HSA contribution limits or how they’re taxed. If your employer chips in money for your HSA and you also have a SEP IRA, that HSA cash won’t count as income for you.
How to Start a SEP IRA
Starting a SEP IRA is easy peasy. Many banks and brokerages have ready-made SEP IRA plans that the IRS approves of. If you’re feeling fancy, you can even create your own custom plan.
Here’s how it works: First, as the boss, you’ve got to give your employees all the info they need about this SEP IRA thing. Then, you can set up individual accounts for each person who’s eligible.
Now, when it comes to timing, you’ve got until your company’s income tax return due date to open and fund a SEP IRA. For example, if you want to get it done for the year 2022, you’ve got until the time you file your 2023 taxes to make it happen.
Is a SEP IRA a Good Fit for You?
SEP IRA contributions can be a tax-deductible business expense for corporations, and if you’re self-employed, they can be deducted on your individual tax return. These tax perks, along with the low setup cost and simplicity, make SEP IRAs pretty attractive to many business folks.
However, there’s a catch: Business owners have to foot the entire bill for contributions to SEP IRAs, and they have to contribute the same percentage for every owner and employee. So, they’re not a perfect fit for every business. SEP IRAs work best for small businesses with only a handful of employees, especially if those employees don’t meet the eligibility criteria. Also, if you’re a high-earning owner of a one-person business, SEP IRAs with their generous contribution limits could be your cup of tea.
Now, if you’re pulling in enough money to max out your SEP IRA contributions, it might be a smart move. But if you’re self-employed without any employees, a solo 401(k) could be an even better option to consider.
