Individual Retirement Accounts (IRAs) are one of the most popular forms of tax-deferred retirement savings accounts. While Traditional IRA accounts are individual (non-employer sponsored) retirement accounts, SEP IRAs behave a little differently. Simplified Employee Pension (SEP) IRAs are tax-deferred retirement plans for individuals who are self-employed, own a business, employ others, or earn freelance income. As simple to administer and inexpensive retirement plan option, SEP IRAs have wonderful tax advantages that make them an attractive option. We’ve put this guide together to go over the ins and outs of SEP IRAs, in addition to answering frequently asked questions such as whether or not employers are able to exclude employees from SEP IRA accounts.
SEP IRAs: A Closer Look
Designed for simplicity, SEP IRAs allow businesses the capability of a company-sponsored pension plan whilst still maintaining an IRA structure and feel. Thereby, SEP IRAs have the potential to be less burdensome, costly, or difficult to manage and run than other types of retirement accounts such as 401(k)s or Traditional and Roth IRAs. As previously mentioned, these accounts are for individuals that are self-employed, own a business, employ others, or earn freelance income. Contributions to the account are considered employer contributions, simply meaning the business makes contributions to the employee account rather than the employee making contributions themself. Thus, there is no need for “matching” as contributions are made by the business entity alone.
Traditional IRAs Vs SEP IRAs
One of the largest differentiating features between traditional and SEP IRAs is that the latter has significantly larger contribution limits. In 2020, Traditional IRAs only allowed for yearly contributions up to $6,000 for individuals under the age of 50. In the same year, SEP IRAs allow for maximum contributions of the lesser of 25% of your compensation or $57,000 on an annual basis. That being said, for self-employed individuals, SEP IRAs allow for significantly more contributions than even a 401(k) would allow, at $19,500 for individuals under the age of 50.
Similar to Traditional IRAs, employees must wait until the age of 59.5 in order to begin taking distributions from SEP IRA accounts without tax penalty. Additionally, required minimum distributions from the account begin at the age of 72 in order to avoid additional significant tax penalties. You are able to contribute to other retirement accounts in addition to your SEP IRA, which can give you larger contribution capabilities in addition to supplying you with tax diversity if you were to open an account such as a Roth IRA. Unfortunately, SEP IRAs don’t come in a Roth ‘form’ so while the money enters the account without taxation, similar to Traditional IRAs, the money is taxed upon distribution of the funds in the account. Be sure to take this into account when calculating total savings, as the face value of the account is not necessarily what you’ll be receiving.
Rules On Exclusion
SEP IRAs are a great option for self-employed individuals, however, it’s important to keep in mind that when or if you begin hiring other staff members, you must contribute to their IRA accounts at the same rate that you contribute to your own. Depending on how much you contribute to your account on an annual basis, total contributions could become quite a large financial burden even with the addition of just 1 or 2 employees.
In order to qualify for contributions to their own SEP IRAs, employees must be at least 21 years old, must make at least $600 a year, and must have worked for your business for at least 3 of the past 5 years. As you look to bring more employees to your company, consider the implications of contributing to all employee’s accounts at the same rate that you contribute to your own. That being said, there is no required amount that must be contributed to employee accounts, meaning if you’re wanting to opt-out of contributions for a year, you’re able to do so, however, you are not able to pick and choose which accounts you contribute to and which ones you don’t. Also, you may face higher tax rates if no contributions are made in a year.
Considering Alternatives: Simple IRAs
Depending on the situation, Simple IRAs may be a more affordable solution to providing your employees with a retirement benefits plan. Simple IRAs allow contributions by both the employee and employer. Employer contributions to Simple IRAs can take one of two forms that are much less expensive than SEP IRAs: 1) employers my select non-elective contributions to employee accounts at 2% of eligible employee’s level of compensation, or 2) employer may match the dollar to dollar contributions of the employee to their account, up to 3% of their level of compensation.
Tax and Investment Implications
Not only are contributions to employee SEP IRA accounts tax-deductible for your business, but another advantage lies in the fact that you can set up and fund these accounts for the prior tax year. That being said, in years where you may have a particularly high tax bill, you could make large SEP account contributions to lessen the impact of the tax burden. Contributions can also be made to employee accounts until the point at which you file your taxes.
While contributions to SEP IRAs are not made by the employee themself, the contributions are 100% vested, or owned by, the employee. This vesting structure allows employees more flexibility to make choices with their investments, as opposed to making selections from pre-selected investments that would be present in an employer-sponsored retirement plan such as a 401(k) program.
Thus, it becomes important to remember that SEP IRAs are a type of investment account, not an actual investment. You should be sure to make a selection of securities that are an accurate reflection of your personal risk-to-reward ratio. Since bondholders are “first in line” to receive payouts from the companies they invest in, bonds are typically the least risky type of investment, as such, they typically receive lower payouts (as a result of lower interest rates) than stock investments would receive. Since shareholders are further down the line to receive payouts from invested companies, there is more risk associated with the uncertainty of returns with stock investments. However, counteracting the higher risk is the possibility of higher returns than an individual might see with investment in bonds.
Your proportional portfolio composition of stocks and bonds should be gauged based upon how old you are, and thus, how close you are to retirement. Since individuals who are older are closer to the point of retirement, they typically desire to take on less risk in order to ensure that their invested savings will be present when they soon reach the point of retirement.
It’s typically advised that individuals close to retirement structure their portfolio of investments more heavily weighted toward bonds than stocks since there is a higher probability of payout on your investments that are most likely close to your retirement date goal anyway. Younger individuals are normally advised to structure their portfolio of investments more heavily weighted toward stocks than bonds since younger individuals have a much longer time before they’ll need to utilize investment savings. The more risk that is taken on, the higher potential for a higher payout, and the longer the individual will have to regrow their investment savings should the market take an unexpected yet inevitable downturn at some point in time.
Selecting a Custodian and Filing With the IRS
Simplicity is a defining characteristic of SEP IRAs, considering the process to set up an account is relatively easy. You should start by filing form 5305-SEP with the IRS. While you are able to fill out and send this form on your own, brokers such as Fidelity or Vanguard allow you to sign up and file this form through their platform which can make the process even more simple.
Before choosing your custodian for your company’s SEP IRAs, you should be sure to take a look at the many companies and offerings that are available. Each custodian will have different qualifications with regard to minimum investments, fees, and investment options offered. Depending on if you’re thinking your company will expand or not, you’ll also want to make sure that your employees will be able to easily access their investment accounts. You’ll also want to make sure that you educated your employees on the implications of their accounts with regard to how to best manage and access their accounts, as an integral part of their retirement planning process.
Determining If SEP IRAs Are the Right Choice For Your Small Business
Advantages of SEP IRAs
The largest advantage of SEP IRAs is the fact that it provides a tax-deferred retirement savings option for self-employed individuals who may not have tax-deferred retirement savings accounts available otherwise. Additionally, this account is a great option for those in the high-income earning years of their career, since the money is taxed when it is taken out of the account in retirement, rather than when it enters the account. An added benefit is the simplicity to set up and run this type of account, which ultimately can be completed through a broker rather than needing to complete this process yourself.
Compared to most other retirement savings accounts SEP IRAs have much larger contribution limits, which has the added benefit of taking advantage of compounding interest that will grow your savings much quicker over time. Compounding interest, simply put, is the interest that you gain on previously earned interest, which has an exponential increasing effect as more money is added to the account, accumulating larger and larger amounts of interest. Finally, SEP IRAs allow more flexibility with regard to contributions, which don’t need to be made every year, with the exception that each individual’s account must be treated the exact same way.
Disadvantages of SEP IRAs
On the other hand, one of the biggest disadvantages to these types of accounts is that each employee’s account must be treated in the same way. This is a non-issue if you are the only employee, but as you seek to hire additional employees, the amount you’ll be able to contribute may decrease with the increased number of individuals needing account contributions. An additional disadvantage is that there’s a lack of ability to make catch-up contributions once an employee passes the age of 50, as is the case with retirement savings accounts such as 401(k)s or Traditional IRAs. That being said, higher contribution limits may make up for this fact. Additionally, while there is an alternative Roth option for traditional IRAs, the same can’t be said for SEP IRAs. While your money is free to grow tax-free, you’ll be taxed on account contributions when you reach the point of distributions retirement, with the added fact that you’re required to begin taking required minimum distributions at the age of 72.
Making the Right Call
Ultimately, the decision of whether or not to utilize SEP IRAs will come down to your vision for your business in the future. Since all employee accounts must be treated and contributed to at the same rate, SEP IRAs may not be the best choice for your business if you’re hoping to expand in the near future. For individuals who see themselves as being the sole member of their company for the foreseeable future, SEP IRAs can provide a wonderful catalyst for tax sheltering that can save you tens of thousands of dollars in taxes each year.
Financial advisors are well versed in all things retirement planning and can help you to make the determination of whether or not SEP IRAs are the right choice for your small business. An advisor can help to shed light on tax implications, and the impact of one account type versus another when it comes to preparing your finances for your many years in retirement. Be sure to contact your advisor to determine what benefit or cost opening a SEP IRA account could have for you, your business, and your employees now and in the years to come.