What is a SEP IRA
SEP stands for Simplified Employee Pension Plan. The SEP was created to allow self-employed individuals, partnerships, sole proprietors, and small business owners to make contributions to their own retirement accounts. But, the SEP also allows business owners to contribute to the SEP IRA accounts of their employees. The contributions made by the employer are made directly to the IRA or Annuity Retirement Account that has been set up by each individual employee. This is different than other retirement accounts in which the employer establishes the account for the employee. Provided the SEP IRA accounts are established by the tax filing due date for the business for that year, contributions can be made.
If an employer chooses to establish a SEP, he or she must set up an account for each eligible employee. In other words, an employer cannot choose to exclude any employee who meets the eligibility requirements. All contributions made to the employees' accounts are made by the employer. This is unlike a 401(k) plan in which the employer generally makes a matching contribution based on an employee's contribution.
Eligibility Requirements for a SEP IRA
Current SEP IRA eligibility requirements are that the employee has reached the age of 21, that he or she has worked for the employer for at least three of the past five years, and that he or she has been paid at least $550 in tax years 2010 and 2011. The only employees who can be excluded from an employer-sponsored SEP IRA program are those who are covered by a collective bargaining agreement, whose retirement benefits have already been negotiated in good faith, and non-resident aliens who are not compensated in US dollars.
Contribution Limits for SEP IRAs
For the self-employed, SEP IRAs provide three key advantages over traditional and Roth IRAs and employer-sponsored 401(k) and Keogh plans. First, annual contributions for employees can be the lesser of 25% of total compensation or $49,000. ($49,000 is the maximum limit for 2010 and 2011 and is subject to an annual cost of living adjustment (COLA) for future contributions.)
For the owner of the business, the contribution is based on the net profit of the business minus one-half of the self-employment tax minus his or her own contribution. Compared to the current $5,000 traditional and Roth IRA limit ($6,000 if the account owner is 50 or older), a SEP IRA provides a much more significant way to reduce current year tax liability while saving for retirement. In most cases, the amount of the contribution is fully deductible for the employer. And, like all traditional IRA accounts, taxes on earnings are deferred until that account owner begins taking distributions after age 59 ½.
Another key advantage of the SEP IRA is that contributions do not have to be made every year. For business owners who operate in cyclical industries or for those who are much more exposed to economic downturns, this provision allows cash to remain in the business during lean years. This can be extremely helpful if a choice needs to be made between funding SEP IRA accounts and keeping enough cash on hand to operate the business.
The third advantage of the SEP IRA is that the business owner may deduct contributions made to employees' accounts, up to the lesser of 25% or the full dollar amount up to $49,000. The business owner's deduction works differently in that his or hers is based on the net earnings from business, minus one-half of the self-employment tax. However, any opportunity to maximize deductions while saving for retirement is usually welcome.
Since SEP IRA contributions are made entirely by the employer, a "catch-up" contribution of $1,000 (for 2011) cannot be made for the employee. However, if the employee has established his or her SEP IRA within a traditional IRA, he or she can usually make the catch-up contribution, depending on the rules established by the account custodian.
Depending on how the SEP IRA has been established by the business owner, it can provide employees with the freedom to select the account custodian of their choice. Unlike other traditional employer-sponsored plans, each employee can choose where his or her account will be established. For example, older employees may want to establish the account at a bank where the contribution is used to purchase a Certificate of Deposit. Younger employees who have several decades before retirement may want to establish accounts at a brokerage house where they can purchase individual stocks and mutual funds. For some employees, the ability to manage their own accounts is preferable to the few options normally provided under an employer-sponsored plan.
Contributing to a SEP IRA and Other Tax-Qualified Accounts
Another benefit of the SEP IRA is that an employer can contribute to it and to another tax-qualified plan, such as a 401(k) or profit sharing plan, at the same time. Furthermore, an individual who is employed full-time and participates in an employer-sponsored plan can also contribute to a SEP IRA if he or she has earned income from self-employment.
This is particularly important for individuals who operate a small business or do freelance work outside their normal full-time employment. Since the entire amount of earned compensation up to $49,000 can be contributed to a SEP IRA, the income tax liability for that portion of income can be reduced to zero. Plus, the ability to put away any additional amount of money into a retirement savings plan should always be considered.
Just like traditional and Roth IRA contributions, SEP IRA contributions must be made by the date the tax return is filed. If an extension to file was requested, the SEP contribution must be made by the extension date.
Rules for SEP IRA Distributions
The distribution rules for a SEP IRA are the same as those for traditional IRA accounts. In order to receive distributions from the account penalty-free, the account owner must be at least 59 ½. The exception to this "Age 59 ½ Rule" are also the same as a traditional IRA, such as disability, qualified education expenses, and medical bills that exceed 7.5% of adjusted gross income.
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