What is a SEP IRA? Understanding a Special Retirement Account for Small Businesses

A SEP IRA, or Simplified Employee Pension Individual Retirement Account, is a special type of retirement account designed for small business owners and people who work for themselves. SEP IRAs help people save for the future by letting them put aside money for retirement in a tax-friendly way. This article breaks down how SEP IRAs work, who can use them, and why they’re useful.

Key Takeaways

• SEP IRA: A retirement account for small businesses and self-employed people. The money put into the SEP IRA grows tax-free until it’s withdrawn during retirement.
• Higher Contribution Limits: For 2024, business owners can contribute up to $69,000 or 25% of an employee’s income, whichever is less.
• Equal Contributions for Employees: Employers who have eligible employees must contribute the same percentage of pay to each employee’s SEP IRA as they do to their own.

What is a SEP IRA?

A SEP IRA is a type of retirement account that helps small business owners and people who work for themselves save for retirement. Think of it as a large savings account where the money can grow without paying taxes until you take it out during retirement.

Who Can Open a SEP IRA?

• Business Owners and Self-Employed People: SEP IRAs are set up by business owners for themselves and their employees.
• Eligibility for Employees: To get contributions in a SEP IRA, employees must:
  • Be at least 21 years old
  • Have earned at least $750 in the current year
  • Worked for the employer in three of the past five years
  • Employers are allowed to be less restrictive in their qualification requirements for their specific SEP IRA plans.

How to Open a SEP IRA

To set up a SEP IRA, follow these steps:

1. Work with a financial advisor or bank to open the account.
2. Fill out IRS Form 5305-SEP to create the plan (this form records the plan’s rules and requirements).
3. Inform eligible employees about the plan.
4. Set up accounts for yourself and your employees.
5. Make contributions to the accounts each year.

Example: If Mr. Chen runs a small bakery, he could set up a SEP IRA with his bank. He would fill out IRS Form 5305-SEP, let his employees know about the plan, and start making contributions.

SEP IRA Contribution Limits

Contribution Limit: Employers can contribute up to $69,000 or 25% of each employee’s salary, whichever is lower. For instance:

• If an employee makes $200,000 a year, the employer can contribute up to $50,000 (25% of $200,000).
• If an employee makes $350,000, contributions are calculated only up to $345,000 (the maximum compensation limit for 2024). This means the employer can contribute up to $69,000 (the highest possible contribution).

SEP IRA Rules

SEP IRAs have special rules to ensure fairness:

1. Equal Contribution Rule: Employers must contribute the same percentage of pay for each eligible employee. If the owner contributes 5% of their income to their own SEP IRA, they must also contribute 5% of each eligible employee’s pay.Example: If Mr. Chen contributes 5% of his $100,000 income ($5,000) to his SEP IRA, he must also contribute 5% of each eligible employee’s pay. For an employee earning $40,000, Mr. Chen would contribute $2,000 (5% of $40,000) to that employee’s SEP IRA.
2. Contribution Deadline: The employer must make contributions by the business’s tax filing deadline, usually April 15 of the following year.
3. Immediate Ownership: Any contributions made are immediately owned by the employee. If an employee leaves the company, they still keep the funds in their SEP IRA.
4. Withdrawal Rules: Withdrawals can be made without penalty after age 59 ½. Taking money out earlier usually results in a penalty, and required minimum distributions (RMDs) must begin at age 72.

Investing a SEP IRA

SEP IRAs can be invested in a variety of assets, including:

• Stocks (shares in companies)
• Bonds (loans to companies or governments)
• Mutual Funds (a collection of stocks or bonds)
• ETFs (similar to mutual funds but traded like stocks)

These investments can help the account grow over time.

Is a SEP IRA a Good Choice?

For a business owner with only a few employees, a SEP IRA can be a great way to save for retirement because of its high contribution limits. But for companies with many employees, SEP IRAs can be expensive since equal contributions are required for each employee.

Additional Resources:

• IRS SEP IRA Guide
• Understanding IRA Contribution Limits

Definitions

• IRA (Individual Retirement Account): A savings account with tax benefits, designed for retirement.
• Contribution: The amount of money put into a retirement or savings account.
• Tax-Deductible: Reduces the amount of income subject to tax.
• Required Minimum Distributions (RMDs): The minimum amount that must be withdrawn each year from certain retirement accounts once you reach a certain age (currently 72).
• Custodian: The bank or financial institution that holds and manages the SEP IRA.

By understanding SEP IRAs and how they work, young people can start planning for future financial decisions and get a jump start on learning about retirement savings!