What is an SEP IRA?

The SEP part stands for Simplified Employee Pension (IRA, of course, is Individual Retirement Account.) Simplified is always good, right? Well, it is fairly simplified, anyway; there are a few limits and restrictions to be aware of but generally it’s a straightforward idea. A simplified employee pension (SEP) IRA is a retirement savings plan established by employers, including self-employed people and sole proprietors, for the benefit of themselves and any eligible employees. [1] In fact, an SEP IRA may be particularly applicable for small-business owners and other self-employed individuals.

The SEP IRA, which can also be self-directed, has one obvious benefit over regular IRAs – the contribution limits are almost 10 times as high, although there are restrictions on eligibility, and the contribution limit depends on income.

The upper contribution limit in 2020 for an SEP IRA is $57,000 (compared with $6,000 for a regular IRA for those up to age 50 and $7,000 for the over 50s.) Sounds wonderful but in fact there is a small catch. The annual contribution limit is the lesser of $57,000 and 25% of one’s income. Therefore, only those whose annual income is at least $228,000 can actually invest up to the maximum limit. With an income of, for example, $60,000, the maximum contribution would be $15,000; nonetheless, this is still considerably better than $6,000.

An SEP IRA is straightforward to open and can – if self-directed – include alternative investments. As with any self-directed IRA, life insurance and collectibles are prohibited – investing in a private art collection, or priceless vintage wines is not allowed, no matter how enjoyable those investments might be! However, permitted alternative investment options include, among others, real estate; precious metals; and oil and gas. Real estate investments can include private mortgages – both commercial and residential – and promissory notes, allowing the holder of an SEP IRA to benefit from the long-term gains available in the real estate and private mortgage market. Once one has opened an SEP IRA, one’s choice of investment depends on personal preference, desired retirement age, and risk tolerance.

How do SEP IRAs work for the self-employed and the owners of small businesses?

SEP IRAs mainly benefit companies with few, or no employees, so they are particularly attractive to small-business owners who are sole proprietors, and other self-employed people. Why? Because if a business owner has employees that the IRS considers eligible participants, then the business owner must match the percentage of income of any contribution they make to their own SEP IRA with an equal percentage for each eligible employee’s income. [2]

Ariella O’Shea, writing for Nerd Wallet in May 2020, explains:

“If you have employees whom the IRS considers eligible participants in your plan, you must contribute on their behalf, and those contributions must be an equal percentage of compensation to your own. Eligible participants are employees who are 21 or older, have worked for you for three of the past five years and have earned at least $600 from you in the past year. Because of that rule requiring equal contributions as a percentage of compensation, a SEP IRA is generally best for self-employed people or small-business owners with few or no employees.”

What are the advantages and disadvantages of an SEP IRA?

Pros:

  • Higher contribution limits, up to almost 10 times the maximum allowed in regular IRAs
  • Ease of setup and administration
  • Contributions are tax-deferred (as with any IRA, other than a Roth IRA)
  • Flexibility – there is no long-term commitment; employers can decide on the amount of their contributions each year, within the allowed limits
  • Small-business owners, eligible employees, and sole proprietors alike can manage their own investment decisions within the limits of the plan; self-directed SEP IRAs can include alternative investments such as real estate

Cons:

  • Unlike a traditional IRA, there is no extra “catch-up” allowance made for investors who are over 50 (though – with the higher limits – most older investors will still be able to make far greater contributions)
  • There is no Roth version of an SEP IRA (with Roth IRAs, contributions are made from post-tax income; this means that they miss out on the tax-deferred benefits of other IRAs during the contributory years but withdrawals on retirement are tax free, whereas – with regular IRAs – withdrawals are treated as taxable income)
  • For small-business owners with employees, proportional contributions must be made for each eligible employee if the employer contributes to their own SEP IRA

Takeaways:

  • A SEP IRA is an employer-sponsored retirement plan that can be set up by sole proprietors, partnerships, and corporations but is of particular benefit to small-business owners with few, or no, employees
  • SEP IRA annual contribution limits are significantly higher than those for traditional IRAs
  • SEP IRAs do not require a long-term commitment to a fixed amount of annual contributions
  • Self-directed SEP IRAs allow participants to manage their own investment portfolios, including alternative investments such as commercial property investments, instead of being limited to the stocks, bonds, and CDs that make up most traditional IRA portfolios [3]

With the huge increase in allowable, tax-deferred contributions, and the option for self-managed portfolios that allows holders to include alternative investments, an SEP IRA is the perfect retirement-planning vehicle for many small-business owners and entrepreneurs.

[1] Brian Beers, January, 2020 https://www.investopedia.com/ask/answers/102714/how-does-simplified-employee-pension-sep-ira-work.asp

[2] Ariella O’ Shea, May 14, 2020 https://www.nerdwallet.com/blog/investing/what-is-a-sep-ira/

[3] Brian Beers, January, 2020 https://www.investopedia.com/ask/answers/102714/how-does-simplified-employee-pension-sep-ira-work.asp

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