SEP IRA: The Best Retirement Account for Self-Employed?
If you’re one of the many self-employed individuals in America, you have quickly realized no one provides benefits for you. You have to provide the benefits for yourself.
This includes finding ways to put away money for retirement.
As a self-employed person, you have many types of retirement accounts you could open. One of those is a Simplified Employee Pension Individual Retirement Account (SEP IRA).
For some people, the SEP IRA may be their best option. For others, a different account may be a better option.
In general:
A SEP IRA might be a good fit for self-employed people with no employees or just a few employees. Self-employed people with many employees may find other account types might work better.
Here’s what you need to know about SEP IRAs so you can decide if they’re right for you.
Keep in mind, these retirement plans can be complex depending on your personal situation. There are also many intricacies and exceptions that you may need to take into account.
For these reasons, you might want to consult a tax and financial advisor. They can take a look at your individual situation and consider your specific retirement planning needs. Then, they can recommend a good self-employed retirement account option for you.
Who Can Open a SEP IRA?
The IRS states that any employer, including self-employed individuals such as sole proprietors, can set up a Simplified Employee Pension (SEP IRA).
To do so, you have to adopt a formal written agreement.
You can do this in one of three ways which include:
- Using the IRS model SEP with Form 5305-SEP, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement
- Using an IRS-approved prototype such as those offered by banks, insurance companies and other financial institutions
- Using an individually designed SEP plan document
For most self-employed small business owners, the easiest option is to open a SEP IRA through a brokerage firm.
Where You Can Open a SEP IRA
Opening a SEP IRA is relatively easy compared to other types of self-employed retirement accounts.
Most major brokerage firms will help you with the process of setting up a SEP IRA.
Popular brokerages that offer these plans include:
- Vanguard
- Fidelity
- Charles Schwab
- TD Ameritrade
Other options also exist. Check with you favorite brokerage, financial advisor or financial institution to see if they offer SEP IRAs.
Contribution Rules and Limitations for SEP IRAs
When contributing to a SEP IRA, there are a few rules to follow.
Employer contribution only
First, only employers can contribute to a SEP IRA.
Employer contributions can only be up to 25% of an employee’s compensation.
When making contributions, the same percentage of compensation must be used for all qualifying plan participants.
That means if you have employees that qualify, you must contribute the same percentage of their compensation as you do your own.
This is why SEP IRAs are best for self-employed people with few or no employees.
Annual maximum contributions
There is also a dollar limit on contributions.
For 2023, the maximum contribution is $66,000 or 25% of compensation, whichever is lower ($68,000 for 2024).
If you’re self-employed, your compensation is considered your net earnings from self-employment after deducting one-half of your self-employment tax and contributions to your SEP IRA.
Unfortunately, this makes your actual maximum contribution less than 25% as a self-employed individual.
Thankfully:
You don’t have to contribute to your SEP IRA every year. That said, when you decide to do so you must do so for all employees.
SEP IRA contributions are always 100% vested immediately. This means each employee gets to keep the contributions even if they leave the company the day after the contribution is made.
Contribution deadline
Contributions to a SEP IRA don’t have to be made by the end of the calendar year. Instead, they can be made up until the business’s tax filing deadline.
Traditionally, the deadline is in March or April depending on what type of entity your business is.
However, you can usually file a six-month automatic extension which could delay the contribution deadline to as late as October.
Withdrawal Rules for SEP IRAs
According to the IRS, the distribution rules for SEP IRAs are the same as regular IRAs.
That means you can start taking withdrawals penalty-free starting at age 59 and ½.
If you take withdrawals before age 59 and ½, you likely will be subject to a 10% additional early withdrawal tax.
Because SEP IRAs are a traditional type of retirement account, you’ll also have to pay taxes on your withdrawals.
Pros and Cons of Using SEP IRAs
As with any retirement account, there are many pros and cons of using a simplified employee pension (SEP) IRA.
Pros
Keep these positive attributes in mind when considering a SEP IRA.
Large contribution maximum
SEP IRAs allow you to contribute up to $57,000 per year if your compensation makes it possible.
Tax-deferred
This is a huge amount of money to be able to set aside for retirement. It can give your business a nice tax break, too.
You do have to pay taxes on the income in retirement, but you may be in a lower tax bracket when you make those withdrawals.
Easy to set up
SEP IRAs allow you to easily set up a retirement plan for you and your employees.
Flexible contribution and establishment Rules
You don’t have to make contributions each year. Instead, your options are fairly flexible. If you have a down year, you can opt for a smaller contribution or no contribution at all.
Unlike some other types of self-employed retirement plans, you can establish and make contributions to a SEP IRA account up until the tax deadline, not the end of the calendar year.
This can give you a tax deductible expense before you file your taxes.
It also allows you to save even more for retirement if you miss the calendar year deadline for other types of self-employed retirement accounts.
Cons
SEP IRAs have drawbacks to consider, too.
Less flexible contribution options
Unfortunately, SEP IRAs don’t have as much flexibility as other types of plans in some ways.
First, you don’t get a Roth and traditional option.
Instead, all contributions are traditional. That means you don’t have an option to pay taxes on contributions now and get tax free money in retirement.
If you have eligible employees, they must get the same percentage contribution you do. This can make saving a large amount for yourself very expensive as you must send the same percentage of compensation to your eligible employees.
SEP IRAs only allow employer contributions, so employees can’t contribute through the plan.
Employees vest immediately
To make matters even less flexible, employees vest in their contributions immediately. They could leave the day after you make the contribution and keep every penny.
No loan options
Finally, SEP IRAs don’t allow you to set up retirement loans as some other plans might allow.
While this is good from the perspective that you and your employees can’t rob your future retirement funds for unnecessary purchases, it is much less flexible if you actually need the money.
Other Retirement or Tax-advantaged Accounts You Can Still Use
You can use other types of retirement accounts in conjunction with SEP IRAs.
That said, you must make sure you don’t exceed contributions limits across all account types. Consult the IRS guidelines or your tax professional for more details about your specific situation.
Other types of retirement accounts may include:
- Traditional IRAs
- Roth IRAs
- 401(k)s
- Other workplace retirement accounts
- Other self-employed retirement plan options
Alternatives for Self-Employed People
If participating in a SEP IRA doesn't seem like a good fit for your business, you have other options as a self-employed person.
Traditional or Roth IRA
First, you may be able to use a traditional IRA or Roth IRA without setting up a business retirement account. If your contributions will be less than the $6,000 limit in 2020 and 2021 ($7,000 for those over 50), this is usually the easiest route.
If you’d like to contribute more, other self-employed retirement plans also exist.
Solo 401(k)
It works much like a regular 401(k), except it’s only for you and potentially your spouse. You can even use a Roth Solo 401(k) if you’re brokerage allows it.
SIMPLE IRA
SIMPLE IRAs are another potential choice for businesses with more than a couple employees, but not more than 100 employees.
The contribution limits may be smaller than for Solo 401(k)s and SEP IRAs, but they’re still higher than a regular IRA.
Employees can also make their own contributions in a SIMPLE IRA, unlike a SEP IRA.
Defined benefit plan
Finally, you can set up a defined benefit plan. These are often called pensions.
They’re extremely complex, are a hassle to set up and can be expensive.
Even so, they can work well in some cases. Consult a professional if you’d like to learn more about how this could work for your business.
Plan for Your Future
As a self-employed person, it can be difficult to provide benefits for yourself like retirement accounts.
The best part:
Opening a SEP IRA is fairly easy and gives you a way to build long-term retirement savings.
Getting started and setting aside money for retirement is a huge first step.
While a SEP plan is relatively easy to set up and may be a great solution for many self-employed people, they aren’t the only choice.
Other options may provide a better solution to sock away money for retirement. They may also allow you to contribute in different ways that make more sense for you and your business.
You should consult your tax advisor or financial advisor to see if a SEP IRA is the best option for you.
