If you're a self employed person or are looking at taking the plunge and becoming an entrepreneur, one thing you have to consider is how you will save for retirement. Since you won't have the option of a 401k, there are several other retirement account type options that you will want to think about using. Among them are:
- SEP IRA
- SIMPLE Plan
- Solo 401(k)
- Keogh Plan
Today I want to look at what many consider one of the better options for tax deferred investing for self employed individuals, the SEP IRA
What Is A SEP IRA?
First of all, let's get the definitions out the the way. What does SEP IRA stand for? When I first started researching the topic I was reading lots of articles talking about how self employed individuals were taking advantage of the accounts, so I assumed it meant “Self Employed IRA”. After reading up on it a bit more I realized that my assumption was wrong. SEP IRA actually stands for Simplified Employee Pension Individual Retirement Arrangement. It is basically an easy way for small businesses to set up a retirement account option for their employees with minimal administrative costs or paperwork.
The SEP IRA is pretty much like a traditional IRA account, although it does have some differences, especially as it relates to the contribution limits. The contribution limits for a SEP IRA are higher.
SEP IRA Rules
- All eligible employees must be provided with plan benefits, and a separate IRA account. If you are self employed with no employees besides yourself, it isn't an issue. If you have employees, it is something to consider.
- Part time employees who are 21 years of age who have worked 3 out of the preceding 5 years, earning $500 or more annually will be eligible.
- Only the employer can contribute to the SEP IRA. If you work for a company that provides one, only your employer can contribute to the account.
- You have until the tax filing deadline of April 15th to establish and fund your SEP IRA.
- Withdrawals from a SEP IRA are treated the same as withdrawals from an IRA account – with a 10% early withdrawal penalty, and taxes charged at your current rate.
- Only income from the business can be contributed – you can’t contribute money from your day job if you have one.
SEP IRA Contribution Limits
Contributions to the SEP IRA are subject to yearly limits, however, they are higher than many other similar account types. For example, for tax years 2009 and 2010 you can contribute up to 25% of an eligible employee’s compensation, up to a limit of $49,000. Extrapolated from the 25% rule the income threshold for a SEP IRA is then $196,000.
Example: Let's say you make $100,000 a year and you're self employed. Under a SEP IRA you would be able to contribute 25%, or $25,000 to your plan.
No catch-up contributions are permitted for older employees.
Benefits Of The SEP IRA
There are several benefits to having a SEP IRA account. Among them:
- If you are an employee at a small business that has a SEP IRA plan, you are 100% vested in the contributions your employer makes, right away. The money is yours!
- Tax deferred investing!
- High contribution limits for self employed individuals.
- Easy to setup. Usually can be done simply by filling out IRS Model Form 5305-SEP
- Less paperwork and administrative costs after the plan is setup.
- Flexible annual contribution obligations – a good plan if cash flow is an issue. You can contribute 10% one year, and then 5% the next if you want.
Do you contribute to a SEP IRA as a self employed individual, or do you have one through an employer? How has it worked out for you? Have we missed any important details about the SEP IRA? Tell us about it in the comments.