If you own a business and want to save for retirement, consider setting up a simplified employee pension individual retirement account. A SEP IRA can help both you and your employees set aside funds for the future. However, make sure your company and your long-term goals are a good match for this type of retirement account.
There are several factors you’ll want to consider before opening a SEP IRA:
— Contribution limits.
— How to invest your SEP IRA.
— Tax benefits.
— Find out if a SEP IRA is a good fit.
— How to open a SEP IRA.
— Rules for providing SEP IRA contributions to employees.
— The deadline for making contributions.
Here’s an overview of what to expect with a SEP IRA and how to open this type of account.
What Is a SEP IRA?
This type of retirement account is designed for small business owners. If you work for yourself or have several employees, you may be eligible for a SEP IRA. “Similar to a traditional IRA, SEPs are retirement accounts in which business owners can make tax-deductible contributions toward their retirement,” says Kevin Dugan, senior partner at Dugan Brown, a retirement planning firm in Dublin, Ohio. The invested funds grow tax-free until they are withdrawn in retirement. When distributions are made, they are considered taxable income.
How to Open a SEP IRA
To start a SEP IRA, you’ll want to follow a number of steps. These include:
1. Work with an advisor to help establish the account with a custodian.
2. Create a formal agreement using IRS Form 5305-SEP.
3. Provide information to employees who are eligible for the plan.
4. Set up accounts for yourself and employees.
5. Make contributions to the accounts.
SEP IRA Contribution Limits
An employer can contribute up to $61,000 or 25% of compensation to a SEP IRA in 2022, whichever is lower. Contributions can only be calculated on up to $305,000 of compensation. The contribution limits for a SEP IRA are significantly higher than the $6,000 to $7,000 limit for traditional and Roth IRA contributions. “The contributions are entirely employer paid,” says Ryan McClung, a certified public accountant and financial planner at Crossroads Advisory in Lake Oswego, Oregon. “There’s no employee contribution option.” The employer is not required to contribute each year.
SEP IRA Contribution Deadline
Typically, any funds you want to place in a SEP IRA will need to be contributed by the time your business files taxes for that year. This is generally April 15 of the following year.
SEP IRA Rules
Before offering a SEP IRA to workers, you’ll want to check if they meet certain criteria. To be eligible for the account, employees must be at least age 21 and have earned at least $650 in compensation during the current year. They also need to have performed services for the company during three of the previous five calendar years.
As an employer, you can choose to be less restrictive on the eligibility, but you’re not allowed to create requirements that are more restrictive. If your employees meet the criteria, you’ll need to have an account for them. If they aren’t eligible and you still choose to include them in the plan, you may do so.
Contributions must be made without discrimination. “Employers must make equal percentage-based contributions to their employee’s accounts as they contribute to their own account, which can be expensive,” Dugan says. If you have three employees who are eligible and decide to make contributions, you’ll need to put funds into all three accounts as well as your own. For instance, if you, as the company owner, contribute 5% of your income to a SEP IRA, you’ll need to contribute that same percentage of income for each employee. If your income is $100,000 and you contribute 5%, or $5,000 of your income to a SEP IRA, you’ll need to contribute the same proportion of income for each employee. If an employee earns $10,000, you’ll need to contribute 5%, or $500, to the employee’s account.
For a company that has many employees, a SEP IRA may not be the best choice. The plans could quickly become costly if the company grows in terms of staff members. However, if your company has a high turnover rate, you may not need to create an account for many employees.
[Read: How to Open a Roth IRA.]
How to Invest Your SEP IRA
Funds that are placed in a SEP IRA can be invested in different ways. “SEPs can invest in a wide range of investments including stocks, bonds, mutual funds and ETFs, which is the same as most retirement accounts,” says Ryan Cullen, co-founder and CEO of Cullen Cioffi Capital Management in Cincinnati, Ohio. “Funds invested into SEP IRAs are immediately vested, meaning the employee now owns the amount invested, even if they were to leave the company.”
Distributions can be taken from the account starting at age 59 1/2. If funds are taken out before then, there is usually a penalty that will need to be paid for early withdrawal. Required minimum distributions must be taken after age 72.
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Update 09/09/22: This story was previously published at an earlier date and has been updated with new information.