What Is SEP IRA, and How Do They Work?
A Simplified Employee Pension IRA, also known as a SEP IRA, is an individual retirement account (IRA) for people who are self-employed or own a small business.
What is an IRA?
An IRA is an individual retirement account that allows you to save money for retirement in a tax-advantaged way. In a traditional IRA, you make contributions to the account out of your paycheck, and you may be able to deduct those contributions on your tax return. Over time, the earnings grow tax-deferred until you withdraw them in retirement (subject to certain limitations and restrictions). Because many retirees are in a lower tax bracket upon retirement than they were during their prime earning years, withdrawing the funds during retirement can save you money because the earnings are taxed at a lower rate.
What is a SEP IRA?
A SEP IRA is simply a traditional IRA for small business owners and other self-employed individuals. The main difference is that a SEP IRA allows you to contribute up to 10 times more than a traditional IRA.
Who Is Eligible For a SEP IRA?
Technically, any type of business, including sole proprietorships, partnerships, and corporations, can open a SEP IRA. The specific rules of a SEP IRA, however, make it most suitable for a business that has only one employee (yourself) or an extremely small number of employees. This is because as the employer who sets up the SEP IRA, you are required to contribute the same amount to all. So if, for example, you want to save 15% of your salary as a contribution to your SEP IRA in 2023, you must also contribute 15% of any employees’ salaries to their retirement accounts as well.
Are There Contribution Limits for a SEP IRA?
A SEP IRA allows you to save up to $66,000 in 2023, subject to the limit that annual contributions cannot exceed 25% of your compensation.
How Do You Set Up a SEP IRA?
The first step is to choose an IRA account provider such as a bank, an insurance company, or other qualified financial institution. You will have a formal written agreement with your account provider, which may include IRS Form 5305-SEP. If you have employees, you will set up a separate SEP IRA account for each employee.
What are the Pros and Cons of a SEP IRA?
Generally speaking, the biggest pro of a SEP IRA is the high contribution limit, as a SEP IRA allows you to stash away almost 10 times more than a traditional IRA. These type of funds are also easy to set up and administer, and can be combined with a traditional or Roth IRA. They are also very flexible, as you do not have to commit to contributing every year. Cons include the fact that the IRS does not allow for catch-contributions for savers 50 and older, and there is no Roth version of a SEP IRA, which means you cannot elect to pay taxes on contributions now and take distributions tax-free in retirement.
Is a SEP IRA Right for Me?
If you are a small business owner, a SEP IRA may be a great way to save for retirement in a tax-advantaged way. Our tax planning experts can help you understand the pros and cons for your specific situation and can advise you on the best path forward. Reach out for a free consultation to see how Prime can help you make smart investments and tax plans for your future!