A SEP IRA reads like a mess of letters, and spelling it out doesn’t necessarily help: The first part stands for simplified employee pension; the second for individual retirement account.
Translation: It’s a retirement account for business owners and self-employed individuals.
Layman’s terms, this is a 401(k) for someone who can’t get a 401(k) through work.
Who is a SEP IRA best for?
The “simplified” bit is no lie: A SEP IRA is a basic retirement account, much like a traditional IRA.
SEP IRA contributions are tax-deductible, and investments grow tax-deferred until retirement, when distributions are taxed as income.
The biggest consideration for a SEP IRA is as follows:
If you have employees who the IRS considers “eligible participants” you must contribute to their SEP IRA on their behalf, and those contributions must be an equal percentage of compensation to your own.
Eligible participants are employees who are 21 or older, have worked for you for three of the past five years and have earned at least $600 from you in the past year.
For example, if an employee worked for you in 2014, 2015 and 2016, you would need to make a contribution for him or her for the 2017 plan year. If you want to stash away 15% of your compensation for yourself, you must also contribute 15% of that employee’s compensation to his or her plan.
Did I mention that Employees own and control their own accounts? They do.
SEP IRAs are usually best for companies with no employees or very few.
What are the contribution limits?
This is where the SEP IRA stands apart from a traditional IRA. A regular IRA allows you to put away $5,500 in 2018. A SEP IRA allows you to contribute up to $55,000.00
There’s plenty of fine print, though; we’d expect nothing less from our friends at the IRS. The annual contributions you make to a SEP IRA cannot exceed the lesser of:
• 25% of compensation
• $55,000 for 2018
The first limit, 25% of compensation, is also the limit for how much you can contribute for each eligible employee.
You can combine a SEP IRA with a traditional or Roth IRA.
If you’re an employee who is covered by a SEP IRA, employer contributions don’t reduce the amount you can contribute to an IRA for yourself, but the amount of your traditional IRA contribution that you can deduct may be reduced at certain higher income levels, due to the combination of both plans.
How do I open a SEP IRA?
Opening a SEP IRA is similar to opening a traditional or Roth IRA, though there are some additional paperwork and reporting requirements, especially if you have employees. Most IRA account providers also offer SEP IRAs, and you can open the account online. We personally use Vanguard. It’s easy and cost-effective.
The IRS outlines three steps for setting up your SEP IRA:
1. Create a formal written agreement. You can do this with IRS Form 5305-SEPor through your account provider.
2. Give eligible employees information about the SEP IRA. You can give them a copy of IRS Form 5305-SEP or get similar information through your account provider.
3. Set up separate SEP IRAs for each eligible employee with the account provider.
How do I invest in my SEP IRA?
It’s important to understand that a SEP IRA isn’t an investment itself; it’s an investment account. Once you’ve opened the account, you can choose from the investments that your account provider offers, a selection that typically includes stocks, bonds and mutual funds.
Once the account is open and funded, you’ll want to invest it according to your age, planned retirement age and risk tolerance. If you have a fairly strong stomach for market swings and a long time until retirement, your investment selection should sway toward stocks, specifically stock index funds, which track a segment of the market and hold a diverse mix of stocks within that segment.
The less time you have until retirement — and the less patience you have for a market downturn — the more you’ll want to allocate toward bonds and bond funds. You can also buy index funds for bonds.
Vanguard allows you to choose from a multitude of funds. I personally like the target accounts. These choose a date and change the composition of funds based on your target retirement year. Fees always need to hover below .30%.
SEP IRA’s are incredibly useful tax saving tools for business owners and employees alike. Use them. Unless you like paying taxes.
Stay rational
-B&T