The finance world is full of jargon and it’s often difficult to keep up with different terms and account types. Many people are familiar with Individual Retirement Accounts, (often referred to as IRAs), but what about a SEP IRA? Let’s learn more about this type of account.

The Basics

“SEP” is short for Simplified Employee Pension. A SEP IRA is similar to a Traditional IRA, but only an employer can contribute funds. Remember that with a Traditional IRA, the maximum IRA contribution allowed in 2021 is $6,000 (or $7,000 for those over 50). A SEP IRA and Traditional IRA are both funded with pre-tax money, grow tax-deferred, and income taxes are due at the time of any withdrawals. As an employee with a SEP IRA, your employer will deposit pre-tax money into your SEP IRA (and can claim a tax deduction for doing so).

A SEP IRA is typically best suited for those who are self-employed or own a small business with only a handful of employees.

For an employee to be eligible for a SEP IRA, they must satisfy the following conditions:

  • Be at least 21 years old
  • Be employed with the company for three of last five years
  • Have earned $600+ during the tax year

Creation & Contributions

It’s easy for small business owners to create a SEP IRA and is generally free to set up with major custodians (i.e., Charles Schwab, TD Ameritrade, etc.). There are also no annual IRS filings. SEP IRAs provide some flexibility to the employer because contributions are optional every year. This can be great for businesses that have variable income from year-to-year or happen to have a slow year profit-wise.

Because each employee has a separate SEP IRA, it’s up to each employee to determine how to invest the employer-funded contributions. Typically, an employer-sponsored 401(k) plan only offers a handful of mutual funds, but with a SEP IRA, you can choose to participate in a variety of investments including (but not limited to) individual stocks, bonds, ETFs (Exchange Traded Funds), and mutual funds.

The most an employer can contribute to a SEP IRA is the lesser of a) up to 25% of an employee’s compensation, or b) $58,000. The biggest caveat for business owners is that any contribution to an employee’s account must be the same percentage of their income they deposit into his/her own account as the owner. Unlike a 401(k), any money the employer contributes to a SEP IRA is the employee’s money to keep immediately. Contributions are 100% vested and cannot be subject to a vesting schedule. (A vesting schedule is simply the length of time that an employee must stay employed with a company to receive the company match with withdrawing funds from the account.)

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Normal Distributions

When it’s time distribute the funds, SEP IRAs act just like Traditional IRAs. If you receive a distribution when you are 59 ½ or older, withdrawals are subject to ordinary income (but not the 10% early withdrawal penalty). Individuals who have not reached 59 ½ yet and elect a distribution are subject to ordinary income taxes and a 10% early withdrawal penalty. In this instance, individuals can avoid the 10% penalty if they have a wavier related to one of the following circumstances:

  • Death (For beneficiaries if you pass away before 59 ½)
  • Disability
  • Specific higher education expenses
  • A series of substantially equal payments (be on the lookout for an upcoming blogpost on SEPP!)
  • First-time home buyers (up to $10,000 for down payment
  • As a result of an IRS tax levy
  • Qualified unreimbursed medical expenses
  • Health insurance premiums while unemployed

Required Minimum Distributions (RMDs)

Once an individual turns 72, the SEP IRA (which was funded with pre-tax dollars) is subject to making Required Minimum Distributions (RMDs). To calculate the amount of your RMD each year, the IRS uses the IRA account value (as of 12/31) for the previous year divided by a life expectancy table value determined by the IRS.

Failing to distribute the RMD is a significant mistake that many investors have made. Any remaining RMD dollars not distributed out of an IRA by 12/31 could result in a 50% penalty. Unlike 401(k) plans which allow you to delay your RMD if you are still employed, you cannot RMD’s with SEP IRAs. Whether you are employed or not does not change the fact that your account is subject to RMDs. See our recent blog post, RMDs Return in 2021 for more information about RMDs.

Overall, SEP IRAs share a lot of characteristics with Traditional IRAs. SEP IRAs can be an efficient way for self-employed individuals or small business owners to save a substantial amount for their own retirement every year while also providing important benefits to their employees.

See our handy guide below to determine whether a SEP IRA or SIMPLE IRA is best for your business:

sep vs simple ira

If you have any questions, please visit Taylor Hoffman’s “Contact Us” page to schedule a time to speak with us!

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