Individual Retirement Accounts for Simplified Employee Pensions (SEP IRAs) are a type of retirement plan. They can be established by a self-employed person or a small business owner.
Who can set up a SEP account?
A high-income self-employed person without employees may consider setting up a SEP IRA account. It can be beneficial for deferring income, saving for retirement, and reducing tax liabilities. For self-employed individuals without employees, it may be worth comparing a SEP account with an individual 401(k) plan to determine which plan is better for you.
Note: An individual 401(k) may allow you to switch between Roth 401(k) contributions (after-tax) and regular 401(k) contributions (pre-tax). It all depends on your tax bracket. Conversely, a SEP account only accepts pre-tax contributions.
An employer looking to reward loyal employees may consider a SEP account as an alternative to a formal profit-sharing plan. SEP accounts typically have lower administrative fees and costs. They also tend to be more flexible.
How much can you contribute to a SEP account?
You can contribute up to 25% of your earned income, which is your net income after business expenses. There is a maximum contribution limit of $61,000 for 2022 and $66,000 for 2023.
How much must you contribute for employees?
You must contribute the same percentage of income for employees as you do for yourself. For example, let’s say you contribute 20% of your eligible compensation to the plan. In this case, you must also make a contribution for each eligible employee at the same 20% of their eligible compensation.
Employees are eligible for contributions if they:
- Have worked for you for three out of the last five years.
- Earn more than $650 in 2022 ($750 in 2023).
- Are age 21 or older.
You have until the tax filing deadline (including extensions) to make contributions to your SEP account for the previous year. The U.S. Internal Revenue Service (IRS) has a dedicated section for SEP IRAs covering additional rules.
How to set up a SEP account?
There are a few steps to set up a SEP account. It is created by executing a written agreement and establishing a SEP account with a qualified financial institution. This could be a bank, a mutual fund company, or a brokerage firm. You can also work with a financial advisor. Then, you open a SEP IRA account for each eligible employee.
You must inform employees that you have established a plan. They should also be notified of the eligibility criteria.
In addition to any employer contributions, employees can make their own regular IRA contributions to their SEP IRA accounts. The deductibility of their IRA contributions is subject to the normal IRA deduction rules, which depend on their total income. It also depends on whether they are participating in an employer-sponsored plan. A SEP account is considered an employer-sponsored plan.
What are the benefits of SEPs?
SEPs offer a variety of benefits. Employers are not required to make contributions every year. Contribution amounts can vary as a percentage of income from year to year.
No additional tax forms are required. With a 401(k) plan, an annual Form 5500 must be filed. However, this is not required for a SEP account.
The employer chooses the financial institution that holds the SEP accounts. However, each employee is responsible for selecting their own investments within the account. This is a benefit for the employer, as they are not responsible for the underlying investments.
SEPs are great for people with side jobs. This is because it allows the worker to fully contribute to a 401(k) plan offered by their employer while using a SEP IRA for self-employed income.
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What are the downsides of SEP accounts?
SEP accounts face some drawbacks for small business owners. Employees are entitled to 100% of the contributions made by the employer as soon as they are made. There cannot be a vesting schedule for contributions in a SEP account. If an employee leaves the day after a contribution is made, they own it. Additionally, let’s say they leave mid-year, and you made a contribution for that calendar year. In that case, you must contribute for them based on the qualified compensation amount they had up until the time they left.
You must provide the same contribution percentage to all eligible employees. In a formal profit-sharing plan, you can categorize employees into groups and have the ability to set different contribution amounts for different groups.
Frequently Asked Questions
Who is eligible for a SEP IRA?
You can use a SEP IRA if you are a small business owner, self-employed individual, or eligible employee at a small company that has a SEP IRA plan. For employees, the general requirements are that they must be at least 21 years old and have earned the minimum required income for the year. They must also have worked for the company for three years or more in the last five years.
How much can I contribute to a SEP IRA?
If you are self-employed or a small business owner, you can contribute up to 25% of your income for the year, as long as you do not exceed the maximum ($61,000 for 2022). Employees do not contribute to their SEP IRA; that is done by the employer.
How do I set up a SEP IRA?
To set up a SEP IRA, you must establish the plan in writing and inform employees of its existence and usage requirements. Then you must set up an IRA account for each eligible employee. You can open the accounts at a bank, broker, or other qualified financial institution. You have until the tax return filing deadline (including extensions) to establish your SEP IRA account.
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Sources:
IRS. “SEP Contribution Limits (Including Grandfathered SARSEPs).” IRS. “SEP Plan FAQs.” IRS. “Simplified Employee Pension Plan (SEP).”
Source: https://www.thebalancemoney.com/sep-iras-for-self-employeds-and-small-business-owners-2388697
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