Pension Plans for the Self-Employed-The SEP IRA


When you work for the man, there are a limited number of retirement programs made available, and if  no plan is extended, you may open an IRA and shelter up to $5,000 if under 50 and $6,000 if age 50 or older for your golden years.

But self-employed workers get an extensive range of pension plan opportunities, and most of them allow you to shelter more than what you can shelter in a traditional or Roth IRA.

One of the more popular plans for the self-employed is the SEP IRA. Note that if you set up a plan for yourself and have employees who have worked three of the last five years, you will be required to make contributions on their behalf. The employees cannot make contributions.

In the past, I’ve noticed that those who set up SEP IRAs are usually sole proprietors with no employees. The sole proprietor (or partner in a partnership) is allowed to shelter up to 25% of his profit from self-employment activities per year. The deduction is taken on page one of Form 1040, line 28.

If you have employees, you are not allowed to discriminate and all eligible employees must be included under a plan. If the employee is under the age of 21, or is an employee covered by a union agreement that provides retirement benefits, or is a nonresident alien who doesn’t have U.S. wages from your business then there is no requirement to provide a SEP IRA plan to them.

Also, the employee must have at least $550 in compensation from your company for the tax year and has worked for your company in at least three of the last five years.

If your legal form is a Sub S corporation, the profit that flows through from your corporation on Schedule K-1 is not counted as earnings from self-employment. You may max out your SEP IRA at up to 25% of your W2 compensation only. Same rule applies to your employees. And there are limits on that which changes from year to year. Check with your plan administrator to see how much you can contribute.

Pam Jacobs, a financial advisor and plan administrator at Edward Jones in Sonoma, Calif., states, “A great way to take advantage of the markets ups and downs is to dollar cost average by depositing monthly into your account. This also eliminates the need to come up with a large sum of money at year end.”

You must be age 59 ½ in order to take withdrawals from your SEP IRA without penalty.

However, you are allowed to take hardship distributions based on an “immediate and heavy financial need (hardship).” According to the IRS, under a “safe harbor” in IRS regulations, an employee is automatically considered to have an immediate and heavy financial need if the distribution is for:

  • Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary;
  • Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments);
  • Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary;
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence;
  • Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary; or
  • Certain expenses to repair damage to the employee’s principal residence.

While the hardship distribution is allowed, it is still subject to the 10% excise tax penalty and regular income tax as well, unless you are older than 59 ½ then you don’t need to worry about the penalty; you pay only the income tax.