What is a SEP IRA?
A SEP IRA is a type of individual retirement account used to help people save for retirement.
The “SEP” stands for simplified employee pension. This type of IRA is a popular option for saving for retirement because they are tax-advantaged and have high contribution limits compared to other types of IRA accounts.
To be eligible to participate in a SEP IRA account you must meet the following requirements.
- You must be age 21 or older
- You must have worked for the employer sponsoring the plan for at least three of the last five years
- And you must have earned at least $600 in wages during the last year
The Tax Benefits of a SEP IRA
The key benefit of the this type of IRA is that it can be funded with pre-tax income, and, once funded, investments can grow without the need to pay taxes until funds are withdrawn.
If you withdraw funds after the age of 59½, only taxes on income and capital gains are due.
If you withdraw funds before the age of 59½, an additional tax penalty of 10 percent is charged.
Therefore, the SEP IRA provides two distinct tax breaks to account holders.
SEP IRA Benefit #1
First, contributing pre-tax income reduces taxable income when contributions are made.
It is important to note that only employers can make contributions to the IRA account (this is discussed below).
For example, if an employee has a total compensation package of $50,000, but the employer allocates $5,000 toward the employee’s SEP IRA, then the employee’s taxable income for that year is $45,000.
However, the income taxes on the $5,000 contributed to the IRA will be due when the money is withdrawn.
SEP IRA Benefit #2
Second, investment gains taxes are also deferred until funds are withdrawn.
This is in contrast to a standard brokerage account, which incurs annual tax liabilities on net realized capital gains.
The tax benefits can really add up over time!
Contributions and Withdrawals
Another distinguishing feature of this type of IRA compared to others is how contributions work.
In the traditional IRA and the Roth IRA, the account owner makes contributions from their paycheck or bank account, and contributions are capped around $6,000 (the IRS adjusts the contribution limits every year).
In a SEP IRA, contributions are made by the employer, and the contribution limit is almost 10 times higher.
In 2019, the IRS limited contributions to SEP IRAs to 25 percent of annual salary or $56,000 (whichever amount is lower).
Again, the IRS adjusts the contribution limits on all retirement accounts on an annual basis, so it’s best to double check with the IRS website before funding an account.
IRA contributions, like other retirement account contributions, still come out of an employee’s paycheck. The difference is that the company handles making the contribution and determining the amount to contribute.
There is a catch to the SEP IRA.
An employer must contribute the same percentage of salary to a SEP IRA for all employees. For example, if the company chooses to contribute 10 percent of a high-level manager’s salary value toward her SEP IRA, then the company must also allocate 10 percent of the salary values for all lower-level employees as well.
This lack of flexibility is a major drawback and has made the SEP IRA practical only for small businesses and self-employed individuals.
As discussed, the this type of IRA provides savers an immediate tax benefit through the ability to defer taxes on income and capital gains. Taxes on income and capital gains are owed when funds are withdrawn.
The SEP IRA is designed to help people save for retirement and thus penalizes account withdrawals made before the age of 59½.
The same penalty applies to traditional IRAs. Another feature shared by the SEP and the traditional IRA is that the IRS requires minimum annual withdrawals beginning at the age of 70½.
The table above summarizes the major benefits and limitations of the SEP IRA account type.
The major benefits include tax savings, high contribution limits, and low cost to set up and administer. It costs almost nothing to set up a SEP IRA; setting up a 401(k), on the other hand, can cost an employer thousands of dollars.
The major drawbacks of the SEP IRA are the limitations regarding withdrawals and the requirement that employers contribute the same percentage of salary for all employees.