SEP IRA Rules
You may not be familiar with the SEP IRA, but it could serve you very well as you save and invest for retirement -- especially if you're self-employed. If you are the owner of a business, it could help you and your employees save a lot of money, too.
The basicsFirst off, know that the term SEP IRA is short for Simplified Employee Pension IRA. Before delving into its details, let's review the two main kinds of IRAs, the traditional IRA and the Roth IRA. With the traditional IRA, you contribute pre-tax money that reduces your taxable income and, therefore, your tax bill for the year. When you withdraw the money in retirement, it's taxed as ordinary income to you your tax hit was deferred. With the Roth IRA, you contribute post-tax money i.e. sums that don't offer any upfront tax break. But you do get a tax break, and a potentially big one, when you withdraw from the account in retirement because you get to take all the money out of the account tax-free.
The SEP IRA rules are similar to those of the traditional IRA, but it has a few twists. While traditional and Roth IRAs are accounts most of us set up on our own, outside our workplaces, SEP IRAs are tied to our jobs. A SEP is set up by an employer (including a self-employed person) and permits the employer (not the employee) to make contributions to the SEP IRA accounts of eligible employees. The employer gets a tax deduction for contributions made and the employee is not taxed on them when they're made, but does have his ultimate withdrawals taxed, at his income tax rate. (Of course, a self-employed person is both employer and employee in this case, so he or she funds their own account.)
Following the rules can keep you out of trouble.
Deadlines and limitsJust as with other kinds of IRAs, SEP IRA rules include deadlines and contribution limits. The deadline for 2015 contributions, like those for traditional and Roth IRAs, is Apr. 15 of 2016. Also, as with traditional (but not Roth) IRAs, you must begin taking distributions from the account once you turn 70 1/2. You can start earlier, without penalties, beginning at age 59 1/2.
The SEP IRA's contribution limits separate it from traditional and Roth IRAs, in a big way. Whereas those more prevalent IRAs have 2015 contribution limits of $5,500, plus a $1,000 catch-up contribution for those aged 50 and older, the SEP IRA's contribution limit is 25% of an employee's income, up to $53,000 in 2015. (That cap is increased over time, to keep up with inflation.) If your income is $100,000, 25% is $25,000. Even for a more modest $60,000 income, it's a very meaningful $15,000.
The power of the SEP IRAMost people won't enjoy $53,000 plopping into their SEP IRA each year, but if you manage to receive $10,000 annually for 20 years and it grows by an annual average of 8%, you'll end up with a hefty balance of more than $490,000. That can make a huge difference come retirement.
The value of the account will grow, tax-deferred, over time. Securities sold along the way won't trigger capital-gains taxes in their year of sale. When withdrawals are ultimately made in retirement, they're considered taxable income at the time and are taxed at income-tax rates, not long-term capital-gains rates.
A big advantage of the SEP IRA over alternatives is that as with traditional and Roth IRA accounts that you set up at a good brokerage, you can invest your money in a very wide range of stocks and bonds, not to mention gobs of mutual funds and ETFs. That's not the case with 401(k)s, for example, which typically feature limited investment menus. SEP IRAs are also fairly simple to set up.
A SEP IRA can help you save enough for a glorious retirement. Photo: Nancy, Flickr.
Details, detailsHere are a few more things to know about the SEP IRA rules:
- Only the employer (or self-employed person) contributes to the account, and there are generally no filing requirements for the employer. (Employees may alsocontribute to their own IRAs, separately.)
- Contributions are made on a pre-tax basis, lowering the employees' taxable income for the year of the contribution.
- The employee is always 100% vested in the accounts, meaning that the contributions made immediately belong to him or her.
- The employer's contribution rate must be the same for all eligible employees.
- The SEP IRA's large contribution limit offers flexibility that's good for businesses with variable cash flow, so that more substantial sums can be contributed in good years and less in not-so-good years.
- Loans from SEP IRAs are not permitted.
- Early withdrawals will face a 10% extra tax if the withdrawer is younger than 59 1/2.
- Beginning at age 70 1/2, required minimum distributions (RMDs) must be taken annually, as with traditional (but not Roth) IRAs.
If you're self-employed, or lead a company without a retirement plan for employees, you owe it to yourself to learn more about SEP IRAs and to consider whether it's right for you or your employees.
The article SEP IRA Rules originally appeared on Fool.com.
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