A Simplified Employee Pension (SEP) IRA is a plan that lets employers contribute to traditional IRAs set up for their employees. A business of any size or the self-employed can open a SEP IRA.
Saving for retirement is an important part of financial planning and there are multiple types of individual retirement accounts (IRAs) to choose from. On M1, clients can choose between a variety of accounts to save for retirement or other long-term financial goals.
A SEP IRA may be a retirement account worth considering for its tax benefits and high contribution limits, making it a powerful retirement savings tool for self-employed individuals and business owners.
In this post, we’ll explain what a SEP IRA is, the advantages and disadvantages of the account, and compare other retirement accounts.
Contributions to a SEP IRA
Contributions to a SEP IRA are tax-deductible for the employer. That gives the employer more incentive to contribute to your SEP IRA.
Employers can contribute up to 25% of the employee’s total compensation or a maximum of $66,000 for the 2023 tax year, whichever is less.
If you’re self-employed, the amount you can contribute is based on your net earnings from your self-employment, but it’s also capped at the lesser of 25% or $66,000 (in 2023).
Your investments grow tax-deferred until you take a distribution in which case it is taxed as income.
A SEP IRA can be a tax-efficient solution for business owners looking to offer a retirement plan for themselves and their employees.
Distributions from a SEP IRA
You can take distributions from your SEP IRA at any time and for any reason. All withdrawals are taxed as income.
In addition to the regular income tax, you may be required to pay a 10% early withdrawal penalty if you make the distribution before age 59 ½. However, there are exceptions to the early withdrawal penalty.
Early withdrawal penalty exceptions
Before 59 ½ any distributions will be included in your taxable income and will be subject to a 10% additional tax unless you meet the following exceptions:
- A first-time home purchase (up to $10,000 lifetime maximum)
- Qualified education expenses
- Expenses related to a birth or adoption (up to $5,000)
- You become totally and permanently disabled
- Unreimbursed medical expenses exceeding 10% of your adjusted gross income
- Paying health insurance premiums if unemployed
Required minimum distributions (RMDs)
You’re required to start withdrawing money at a certain age. These are called required minimum distributions (RMDs).
You must start taking withdrawals from your SEP IRA when you turn 72. The IRS recently moved to age 73 if you turn 72 after Dec. 31, 2022.
You do not need to start taking RMDs until April 1st of the calendar year following the year you turn 73. For example, if you turn 72 in 2023 and you turn 73 in 2024, you do not need to take the RMD until April 1st of 2025.
If you do not withdraw the required amount, you may be subject to a 50% penalty of the amount you should have withdrawn.
Advantages of a SEP IRA
There are some advantages to a SEP IRA account.
- Contributions are tax-deductible: The employer can deduct 25% of compensation or the lesser of contributions on their tax return.
- High contribution limit: $61,000 for the 2022 tax year or $66,000 for the 2023 tax year.
- Ease and flexibility: SEP IRAs are easy to set up and do not require any commitment to contributing every year.
- Combination: You can receive contributions from your employer to a SEP IRA while also contributing to your own traditional or Roth IRA.
Disadvantages of a SEP IRA
There are some disadvantages to a SEP IRA account.
- Taxed withdrawals: Withdrawals are taxed as regular income tax. If you’re concerned about paying income tax on IRA withdrawals after you retire, consider opening a Roth IRA.
- RMDs: Starting at age 73, you are required to take distributions.
- Taxed distributions before 59 ½: Any distributions before 59 ½ are taxed as income and subject to a 10% penalty unless the reason qualifies as one of the early withdrawal exceptions.
Comparing a SEP IRA to other types of retirement accounts
While a traditional IRA is very similar to a SEP IRA, there are differences between Roth and SIMPLE IRAs.
Traditional IRA vs SEP IRA
A SEP IRA is a traditional IRA that holds contributions made by an employer under a SEP plan.
Roth IRA vs SEP IRA
A SEP IRA has a much higher contribution limit than a Roth IRA. But Roth IRAs provide tax-free growth and withdrawals during your retirement whereas a SEP IRA offers tax-deferred growth on your investments.
Read more: traditional IRAs vs Roth IRAs.
SIMPLE IRA vs SEP IRA
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is an account that allows employees and employers to contribute tax-deferred to traditional IRAs set up for employees of the business. SIMPLE IRAs require businesses to be smaller than 100 employees and require the employer’s contribution to be up to either a matching contribution of up to 3% of the employee’s compensation or a 2% nonelective contribution. SIMPLE IRAs let both the employee and the employer contribute.
A SEP IRA allows a business of any size to open one and allows employers to contribute up to 25% of the employee’s total compensation or a maximum of $66,000 for the 2023 tax year, whichever is less. A SEP IRA only allows the employer to make contributions.
The M1 line
A SEP IRA can be a valuable retirement savings option for self-employed individuals or businesses. It allows for high contribution limits and tax-deductible contributions. However, it taxes withdrawals and has RMDs. When comparing a SEP IRA to other types of retirement accounts, it’s important to consider the unique features and benefits of each option to determine the best fit for your financial goals and needs.
M1 and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only. It is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.