The SEP IRA is a retirement plan designed to benefit self employed individuals and small business owners. Sole proprietorships, S and C corporations, partnerships and LLCs qualify.
SEP IRA contribution limits
The 2015 SEP IRA contribution limit is $53,000 (2014 limit is $52,000). Contributions to a SEP IRA are generally 100% tax deductible and investment earnings in a SEP IRA grow taxed deferred. Withdrawals after age 59 ½ are taxed as ordinary income. Withdrawals prior to age 59 ½ may incur a 10% IRS penalty as well as income taxes.
A SEP IRA has broad appeal due to its high annual contribution limits, completely discretionary and flexible annual contributions and minimal administration. SEP IRA plans can be established by a one person business or by a business owner with employees.
- Most frequently a SEP IRA is established by a business owner without employees and is discussed in detail below.
- In special situations a SEP IRA may be an ideal retirement plan for a business owner with employees.
Learn more about a SEP IRA with Employees.
SEP IRA for a self employed business owner without employees
The calculation of how much can be contributed to a SEP IRA is dependent on whether your business is a corporation and you receive a W-2 as compensation or if you are taxed as a sole proprietorship and receive compensation as personal income. Examples of both are shown below.
Business owner receives compensation as W-2 income
An S or C corporation, an incorporated partnership or a LLC electing to be taxed as a corporation pays the business owner a W-2 salary. In this situation, the annual SEP IRA contribution can be between 0% to 25% of the owner's W-2 salary up to the SEP IRA contribution limit. SEP IRA contributions are generally 100% tax deductible as a business expense.
Business owner receives compensation as personal income
When a SEP IRA is established for a unincorporated business such as a sole proprietorship, unincorporated partnership or a LLC electing to be taxed as a sole proprietorship, annual contributions are made into your SEP IRA account between 0 to 20% of your net adjusted self employment income (or net adjusted business profits). SEP contributions are flexible and the percentage of contribution can be changed at any time and may be skipped in a bad year. SEP IRA contributions are generally 100% tax deductible from personal income.
Calculating net adjusted self employment income.
Net adjusted self employment income is calculated by taking gross self employment income and then subtracting business expenses and then subtracting 1/2 of the self employment tax. An annual SEP IRA contribution can be made between 0% to 20% of that figure up to the annual SEP IRA contribution limit.
SEP IRA contributions are flexible and the percentage of contribution can be changed at any time. SEP IRA contributions are generally 100% tax deductible from personal income.
SEP IRA Calculator
To determine how much you can contribute to a SEP IRA based on your income use the interactive SEP IRA calculator.
When is the SEP IRA setup and contribution deadline?
Generally a SEP must be established and funded by your tax filing deadline. Generally, filing extensions extends the period for establishing and funding the SEP plan. For a sole proprietor April 15th would be the deadline to establish and fund a SEP for the prior tax year. If an extension was filed a sole proprietor can establish and fund a SEP IRA by October 15th.
A self employed business owner with no full time employees other than a spouse may also want to consider an Individual 401k as well as a SEP IRA.
- A SEP IRA allows a contribution of up to 20% of net self employment income or 25% of W-2 wages, but an Individual 401k frequently permits a larger contribution at the same income level and may allow a greater contribution.
- Another feature of an Individual 401k versus a SEP IRA is an Individual 401k permits a loan up to 50% the value of the account up to a maximum of $50,000
SEP IRA vs Individual 401k
A comparison of these self employed retirement plans
Selecting the right retirement plan can be confusing and the subtle differences between options can sometimes be overlooked.
If you are a self employed individual or an owner and spouse business and are considering a SEP IRA or Individual 401k reading this information should help you make your decision easier by explaining the differences simply.
The SEP IRA and Individual 401k are the two most common retirement plans chosen by successful self employed individuals and owner and spouse businesses due to their high contribution limits and flexible annual contributions. Individual 401k plans have greater administrative responsibilities than a SEP, but may allow a larger annual contribution at identical income levels due to the way the annual contribution is calculated.
Another issue to consider is whether you’d like to have the option of borrowing against your retirement plan by using your retirement plan's balance as collateral and receive an Individual 401k loan. IRS rules do not permit a loan in a SEP IRA, but an Individual 401k loan of up to half of the plan's value up to a $50,000 maximum is allowed.
- Features: 2015 SEP IRA contribution limit is $53,000.
- .Advantages: Easy to setup and low administrative responsibilities.
- Disadvantages: An Individual 401k may provide a larger contribution and tax deduction compared to a SEP IRA. For those age 50+ there isn't an additional $6,000 catch-up contribution provision like there is with the Individual 401k.
Who would be appropriate for a SEP IRA?
Simply, the SEP IRA is a great choice for self employed individuals or owner and spouse businesses who would like to contribute up to 25% of their W-2 wages (if incorporated) or 20% of net self employment income (if taxed as a sole proprietorship) up to the SEP IRA contribution limit. A SEP provides high maximum contribution limits, but an Individual 401k may allow a greater contribution at the same income level.
A final point to consider is IRS rules do not permit loans with a SEP IRA. A SEP IRA is the right choice if you aren't in need of a loan and don't anticipate needing one in the future.
It is important to note that you can set up a SEP IRA and convert to an Individual 401k in the future if you change your mind and either want to receive an Individual 401k loan or if you want to contribute more than the calculations of a SEP IRA will allow. Converting from a SEP IRA to an Individual 401k and transferring retirement assets from a SEP IRA to a new Individual 401k can be accomplished by completing some minor administrative paper work.
If this sounds like you then keep it simple and set up a SEP IRA.
- Features: 2015 Individual 401k contribution limit is $53,000 ($59,000 if age 50+ due to a "catch-up" provision). Loans are permitted in an Individual 401k.
- Advantages: Potentially greater retirement contributions at identical income levels compared to a SEP IRA. Individual 401k loans are permitted up to 50% of the total 401k value with a $50,000 maximum.
- Disadvantages: Potentially greater administrative responsibilities and administrative fees compared to a SEP IRA.
Who would be appropriate for an Individual 401k?
The Individual 401k and the SEP IRA have comparable maximum limits, but due to the way the contribution is calculated a self employed individual may be able to contribute more into an Individual 401k versus a SEP IRA at the same income level, therefore maximizing retirement contributions and valuable tax deductions.
Here's how the calculation works. In 2015 participants in an Individual 401k can contribute up to 100% of the first $18,000 ($24,000 if age 50 or older) of W-2 wages (if they are incorporated) or if net self employment income (if they are taxed as a sole proprietorship). In addition, a profit sharing contribution can be made up to 25% of W-2 wages or 20% of net self employment income. The contribution limit calculation in an Individual 401k is important because it allows you to potentially save more than a SEP IRA at the same income level.
To determine how much you can contribute based on your income use the interactive Individual 401k calculator.
Another important distinction between the SEP IRA versus the Individual 401k is the loan feature. An Individual 401k loan may be considered a valuable feature to some self employed business owners.
Learn more about an Individual 401k loan.
For many successful business owners the decision of which retirement plan to choose comes down to either a SEP IRA or Individual 401k. Simply stated there are 2 primary advantages of the Individual 401k over the SEP IRA.
- Potentially greater retirement contributions at the same income level, therefore maximizing retirement contributions and valuable tax deductions.
- The option of a tax free loan using the balance of the plan as collateral via an Individual 401k loan.
If you value the loan feature or want to maximize your annual retirement contributions then you should consider an Individual 401k. If not, the simplicity of a SEP IRA makes it the best choice for you.
SEP IRA FAQs
What is a SEP IRA?
A SEP IRA (Simplified Employee Pension) is a retirement plan that is popular with many small business owners and self employed individuals. A SEP IRA allows contributions of up to $53,000 for 2015 ($52,000 for 2014).
Who is eligible for a SEP IRA?
Sole proprietors, partnerships, incorporated and unincorporated small businesses including Sub S corporations and individuals with self employment income even if they are covered by their employers retirement plan such as a 401k, 403b or 457 plan.
Who is best suited for a SEP IRA?
Employers who wish to make large tax deductible retirement plan contributions both for themselves and on behalf of their employees (who therefore receive a substantial tax free fringe benefit). This could be beneficial in attracting or retaining key employees in a competitive labor market.
Another desirable situation is a person with a sideline business with self employment income in addition to a main job which provides a retirement plan such as a 401k. Contributions can be made to a SEP IRA with self employment income even if you participate in a 401k, 403b, or 457. This is good for such individuals if their desire is to save for retirement while saving current taxes.
How are SEP IRA contributions calculated?
The employer decides at what level the plan will be funded, from 0% to 25% of compensation (0%-20% for unincorporated businesses). The % must be the same for the employer as for the employees. Each employee has his/her own SEP account and the employer pays the entire contribution. The employee receives this fringe benefit tax free and it's tax deductible for the employer. Contributions to a SEP is optional each year so years can be skipped if finances dictate or implemented if profits exceed a certain threshold as an incentive to employees. Therefore a SEP IRA offers maximum flexibility. Because a SEP IRA is so generous to employees it may engender employee loyalty and minimize turnover.
Which employees must be included in the plan?
All employees age 21 or older who earned $600 or more during the current year if they have worked for the business in 3 of the past 5 years must be included in a SEP IRA plan.
When is the deadline for a SEP IRA to be established and funded?
Sole proprietorship, partnership or a LLC taxed as a sole proprietorship:
- A SEP IRA must be established and funded by the individual's personal tax filing deadline, generally April 15th (or October 15 if an extension was filed).
S or C corporation or a LLC taxed as a corporation:
- A SEP must be established and funded by the corporate tax filing deadline, generally March 15th (plus extensions).
When may the funds be withdrawn?
As with other retirement plans, the SEP IRA allows withdrawals at age 59 ½ and requires distributions at age 70 ½. Distributions before age 59 ½ usually incur taxes and penalties with some exceptions such as medical or educational expenses or the purchase of a home. Consult with your tax advisor to determine if you may qualify for those exceptions.