What Is a SEP IRA?

IF YOU OWN A BUSINESS and want to save for retirement, consider setting up a simplified employee pension individual retirement account. A SEP IRA can help both you and your employees set aside funds for the future. However, make sure your company and your long-term goals are a good match for this type of account.

Here’s what to consider before opening a SEP IRA:

  • Contribution limits.
  • How to invest your SEP IRA.
  • Tax benefits.
  • Find out if a SEP IRA is a good fit.
  • How to open a SEP IRA.
  • Rules for providing SEP IRA contributions to employees.
  • Understand the SEP plan’s flexibility.

Here’s how to tell if a SEP IRA will be a good fit for your small business:

SEP IRA Contribution Limits

A SEP IRA is designed to help self-employed individuals and small business owners and their employees save for retirement. “SEP IRAs provide the self-employed business owner the ability to contribute a potentially larger amount than a traditional or Roth IRA,” says Archie Ponce, a certified financial planner and executive vice president of Optima Asset Management in Dallas. For 2019, the maximum amount an employer can contribute is set at $56,000 or 25 percent of compensation. That’s significantly more than the $6,000 to $7,000 limit for traditional and Roth IRA contributions.

How to Invest Your SEP IRA

Funds that are placed in a SEP IRA can be invested in different ways. “Mutual funds, stocks, real estate and annuities are some assets that can be held in a SEP,” says Doug Mitchell, owner of Ogletree Financial Services in Auburn, Alabama. Distributions can be taken from the account starting at age 59 1/2. If funds are taken out before then, there is usually a penalty that will need to be paid for early withdrawal.

Tax Benefits of a SEP IRA

SEP IRAs can provide significant tax savings to small business owners. “The tax benefits to the employer are tax-deduction and tax-deferral benefits for the self-employed individual personally,” Ponce says. Employers can also take tax deductions on a business level for contributions made on behalf of employees.

Determine Whether a SEP IRA Is a Good Fit

In most cases, a SEP plan works for smaller firms rather than larger corporations. “The SEP IRA is powerful for closely held businesses because it requires the employer to contribute the same percentage of income for each employee,” says Niko Finnigan, a partner at Delta Wealth Advisors in Indianapolis. If you own the company and contribute 5 percent of your income to a SEP IRA, you’ll need to contribute that same percentage of income for each employee. If your income is $100,000 and you contribute 5 percent or $5,000 of your income to a SEP IRA, you’ll need to contribute the same proportion of income for each employee. If an employee earns $10,000, you’ll need to contribute 5 percent, or $500, to the employee’s account.

For a company that has many employees or plans to hire more workers in the next year, a SEP IRA may not be the best choice. “The employer would be required to contribute to every employee’s SEP IRA, which can quickly become costly,” Finnigan says.

How to Open a SEP IRA

You’ll need to follow a few steps to start a SEP IRA, beginning with a formal written agreement. You will need to complete IRS paperwork, work with an account provider, provide information to employees and set up a SEP IRA for each employee. “SEPs are very easy to establish and have virtually no filing requirements, which makes them very attractive for small businesses,” says Ryan Repko, a certified financial planner at Ruedi Wealth Management in Champaign, Illinois.

Contributions for Employees

Before offering a SEP IRA to workers, you’ll want to check if they meet certain criteria. To be eligible for the account, employees must be at least 21 years old and have earned at least $600 in compensation during the current year. They also will need to have performed services for the company during three of the previous five calendar years. “Employers can be less restrictive on the eligibility but may not set requirements to be more restrictive,” Ponce says. So if your employees meet the criteria, you’ll need to have an account for them. If they aren’t eligible and you still choose to include them in the plan, you may do so.

If your company has a high turnover rate, you may not need to create an account for many employees. “The business could save money by establishing a SEP IRA because it would not have to make contributions on behalf of employees who haven’t worked for the company for at least three years,” Repko says. “The disadvantage is that any employee who has worked for the company for three years and is at least 21 years of age is going to be covered by the plan, even if they only work part time.”

Understand the Plan’s Flexibility

While you may want to make contributions every year to a SEP IRA, it’s not necessary. “The employer contributions are discretionary from year to year, meaning there is no requirement for the company to make contributions each year,” Repko says. “The business can choose when to make contributions, which can be a valuable planning tool so the contributions can coincide with profitable years.” During a low year, you might choose to forego the contributions.

One requirement is that contributions must be made without discrimination. During a year that contributions are made, they must be made for all eligible employees. If you have three employees who are eligible and decide to make contributions, you’ll need to put funds into all three accounts as well as your own.