Learn more about the workings and features of the SEP-IRA to decide whether it may be right for you.
Benefits of a SEP-IRA
Compared to a 401(k) retirement plan, a SEP-IRA is relatively simple to start and manage. It’s easy to set up and operate, and administrative costs are low, according to the Internal Revenue Service, and no annual filing is required. Plus, annual contribution limits are much higher than you’ll find in most other retirement plans. As with other tax-advantaged retirement plans, contributions to a SEP-IRA can be invested tax-deferred until the money is withdrawn at retirement, beginning at age 59 1/2 and no later than 72. If any money is withdrawn before age 59 1/2, it is subject to income tax plus a 10% penalty tax.
Deductible
Business owners can deduct SEP-IRA contributions as a business expense (limited to 25% of compensation paid to participants). And employees do not have to count contributions in their gross income, so they’re considered pre-tax income like they would be in a 401(k).
Contribution Limits
One of the most appealing aspects of a SEP-IRA is its high contribution limits. Contributions for employees can equal as much as 25% of their annual compensation, and contributions for business owners can amount to 25% of their net earnings from self-employment. The maximum amount for both employees and employers is $61,000 for 2022, up from $58,000 in 2021. Compare that to the 401(k), which has a maximum contribution limit of $20,500 in 2022 (up from $19,500 in 2021), plus an extra $6,500 if you’re 50 or older and so qualify for a catch-up contribution), and you can see the obvious benefit for those who are looking to save more tax-deferred dollars.
Flexibility With Other Plans
Even if you participate in another workplace retirement plan, like a 401(k), you can still contribute self-employment income to a SEP-IRA, so it’s a great plan for people who earn income from a side business, including freelance or contract work. However, contributions made to a 401(k) or profit-sharing plan—but not to a SIMPLE IRA—must be subtracted from the total amount that can be contributed to your SEP-IRA.
Calculating Self-Employment Income
If you are self-employed, figuring out how much you can contribute each year can be slightly tricky. You can calculate net adjusted self-employment income by taking your gross income, subtracting business expenses, and then subtracting half of the self-employment tax. But you must include your contribution to the SEP-IRA in your business expenses. Consult with an accountant or tax advisor if you have any questions. Contributions to a SEP-IRA are a little less flexible once additional employees enter the picture. That’s because employers must contribute the same percentage for every employee. Let’s say you’re a dentist who wants to contribute 20% of your income to a SEP-IRA. You must also contribute 20% of each of your employees’ salaries to a SEP-IRA as well. All employees who are age 21 or older, have worked for you for three of the past five years, and earned at least $650 (for 2021 and 2022) are eligible for this contribution. (Employees working under union agreements may be excluded.)
Other Options
There are other retirement plans for small businesses and self-employed individuals, such as 408(k) plans, SIMPLE IRAs, solo or self-employed 401(k)s, Keoghs, or even regular 401(k)s for small businesses (which may go under the terminology Single(K) or Individual(K)). It makes sense to compare them all before deciding which one is right for you.
