Whether you’re a freelancer, consultant or small business owner, the Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) can help you and your employees save for retirement, without a 401k. In fact, a business of any size can set up a Simplified Employee Pension IRA.
Here’s your answer if you’re pondering, “What is a SEP IRA?” It’s an account that enables smaller businesses and solopreneurs to contribute to a retirement plan inexpensively and simply.
A SEP IRA account is a traditional IRA, but with distinct contribution limits.
How Does a SEP IRA Work?
The employer completes IRS form 5305-SEP. The SEP IRA must be the employers only retirement account (except another SEP).
If the employer has employees, then she sets up traditional SEP IRAs for each eligible employee. Unlike traditional and ROTH IRAs, only the employer contributes to the account, not the employee. And, the employee is always vested.
The contribution rate must be the same for all employees.
The employer can change the contribution rate at will, which is helpful for cyclical business owners.
What Are the Rules of a SEP IRA?
Who Can Set up a SEP IRA — Company Eligibility: Both incorporated and unincorporated business are eligible to set up a SEP IRA, including:
- Sole proprietor
- Subchapter S
- C Corporation
SEP IRA Employee Rules: If the employee is at least 21 years old, has worked for the employer for three of the last five years and earned at least $600 the employer must include the employee in the company plan.
At the employer’s discretion she can include employees who don’t meet the previously mentioned criteria.
How Much Can You Contribute to a SEP IRA?
The maximum contribution amount is the $56,000 for 2019 or 25 percent of the employee’s pre-tax pay, whichever is less.
Of course, the employer or solopreneur can contribute less than that amount.
If you’re a consultant and earn $180,000, you can contribute up to $45,000 into a SEP IRA. The $45,000 is 25 percent of your income. For bulking up retirement savings, the SEP IRA is a better option than the maximum $6,000 allowed for the traditional or Roth IRA contribution.
Where to Open a SEP IRA?
Most major brokerage firms offer the SEP IRA account. If you’re already banking or investing with E*Trade, TD Ameritrade or Vanguard, it’s easy enough to set up the SEP IRA.
Although, if you want a set it and forget it option for you and your employees, consider opening a SEP IRA account with a robo-advisor.
Robo-advisors do the heavy lifting for you and your employees by offering a quiz to determine the investor’s risk tolerance, goals and time horizon. Then the robo advisor creates an investment portfolio to meet the investor’s responses.
Currently, these robo-advisors offer a SEP IRA account:
- Personal Capital
- TD Ameritrade
Pros and Cons of a SEP IRA
The Pros of a SEP IRA: There’s a lot to like about the SEP IRA.
The account allows employers to offer employees tax deferred retirement benefit.
The self-employed have a path to shelter income from taxes and save for retirement tax deferred.
The administrative costs of a SEP IRA are low in contrast with a 401(k) plan.
A SEP IRA is easy to set up operate.
The flexible annual contribution option makes a SEP IRA ideal for businesses with uneven cash flow.
For employers, the contributions made into each employee’s SEP IRA account are tax deductible as a business expense.
The SEP formation and contributions can occur anytime before the tax-filing deadline. This is better than some comparable retirement plans.
The Cons of a SEP IRA: The employer must contribute equally for all eligible employees as long as the employee meets minimal IRS guidelines.
Employees aren’t allowed to make contributions to the plan.
Unlike many 401(k) plans, loans aren’t allowed from a SEP IRA.
Like traditional IRAs any withdrawals before age 59 ½ are taxable and subject to an additional 10 percent penalty.
SEP IRA Alternatives
Although a SEP IRA is called a Simplified Employee Pension, it’s not actually ‘simple.’ As is the case with most government and tax related programs, there are eligibility requirements and rules to follow.
If the SEP IRA isn’t for you, consider other retirement planning alternatives:
- Traditional or Roth IRA
- Solo 401(k)
- Simple IRA
- Defined benefit plan
SEP IRA Wrap up
Saving for retirement in a tax-deferred account is a no brainer. If you’re a small business owner or solopreneur, it’s easy to overlook this important financial task. The high SEP IRA contribution limits make it an ideal account for those years when your income soars. During the less-profitable years, you’re not locked into a specific contribution amount. With easy set up and low administrative fees, the SEP IRA is a convenient way to save for retirement and shelter current income from taxes.
Barbara A. Friedberg, MBA, MS is a veteran portfolio manager, expert investor, and former university finance instructor. She is editor/author of Personal Finance; An Encyclopedia of Modern Money Management and two additional money books. She is CEO of Robo-Advisor Pros.com, a robo-advisor review and information website. Additionally, Friedberg is publisher of the well-regarded investment website Barbara Friedberg Personal Finance.com. Follow her on twitter @barbfriedberg and @roboadvisorpros. As of this writing, she does not hold a position in any of the aforementioned securities.