How to Use a SEP-IRA Retirement Plan

Learn what you need to know about saving for retirement with a SEP-IRA.

Laura Adams, MBA
6-minute read
Episode #217

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Nadine S. sent in a question about SEP retirement plans. She says:

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I work a full time job for a corporation where I contribute to a 401(k) with a company match. I also have a Roth IRA that I personally contribute to. In addition, I opened a business (a dance and performing arts school) where I am the sole employee. I’d like to learn more about contributing to a SEP and any limitations to having one if I also contribute to a 401(k) and a Roth IRA.

How to Use a SEP-IRA Retirement Plan

If you’re self-employed or own a small business with employees, you might be like Nadine who’s looking for a way to sock away more money for retirement. If you want a great way to invest more of your income—and get a nice tax break—one option is a SEP or Simplified Employee Pension.

In this article I’ll tell you what you need to know about who can have a SEP, how to set one up, and the limitations that exist if you also contribute to other kinds of retirement accounts.

What is a SEP-IRA (Simplified Employee Pension)?

A SEP is also known as a SEP-IRA and it’s a retirement plan that allows an employer or someone who’s self-employed to set aside money for themselves and for their employees. A SEP-IRA is available to any size business—whether you’re a sole proprietor, a partnership, or a corporation—and it’s very simple and inexpensive to set up and maintain.

You can use a SEP-IRA to create a healthy retirement nest egg whether you’re a full-time business owner or a part-time entrepreneur, like Nadine. The “IRA” part comes in because contributions are made on a pre-tax basis to a traditional IRA (Individual Retirement Arrangement). You set up the account but it’s always owned and controlled by the employee or by you if you’re an owner-employee. 

How Much Can an Employer Contribute to a SEP-IRA?

First I’ll discuss the rules that apply if you have a business with employees, and then I’ll tell you how a lone self-employed person can take advantage of a SEP. A defining feature that you need to understand about SEP-IRAs is that employees can never contribute their own money to the plan—contributions can only come from the employer. You can make SEP-IRA contributions for each of your employees (including yourself) up to 25% of each employee’s compensation for a maximum amount of $49,000 in 2011.

Know the Rules of a SEP-IRA

But the rules don’t allow you to be stingy because you have to offer a contribution rate that’s uniform for all employees, including yourself. That means if you create a SEP-IRA for yourself, you also have to set one up for each of your eligible employees and contribute the same percentage to their accounts as you do for yourself. For instance, if you put 10% of your pay in a SEP-IRA, you also have to contribute 10% of each employee’s pay to their SEP-IRA. If you increase your contributions to 12%, you also have to increase their contributions to 12%.

However, there’s no requirement to make any contributions at all. If you have a bad year you can contribute nothing and if you have a profitable year you can turbo charge your contributions up to the maximum amount. You get a nice tax break for being so generous because, in general, the contributions you make to your employees’ SEP-IRAs are tax deductible.

How Much Can a Self-Employed Person Contribute to a SEP-IRA?

If you set up a SEP-IRA for yourself, you also have to set one up for each of your eligible employees and contribute the same percentage to their accounts as you do for yourself.

Now let’s cover the rules for a SEP-IRA if you’re self-employed and don’t have any employees. Maybe you’re a one-woman web designer, actor, bookkeeper, cat-sitter, or a dance teacher like Nadine. You can make contributions on behalf of yourself if you have net earnings from the business. You can contribute an amount to your own SEP-IRA that totals 20% of your net self-employment earnings up to $49,000 for 2011. But if you have a net loss in your business, you can’t make any contributions.

There are some special rules for figuring how much of your SEP-IRA contributions are tax deductible when you’re self-employed. There’s a worksheet that you use to calculate your deduction in IRS Publication 560, Retirement Plans for Small Business.

Can You Have a SEP-IRA and Other Retirement Accounts?

A SEP-IRA is a completely separate retirement plan that you can have in addition to a regular IRA, a Roth IRA, or even another workplace plan—like a 401(k)—if you’re a go-getter like Nadine and work a job in addition to having your own business. However, the total amount you can contribute to an employer plan plus your SEP-IRA contributions is limited to 100% of your compensation up to $49,000 for 2011.

Let’s say you’re 35 years old and have a day job as a computer programmer where you earn $75,000 and a part-time business as a web site designer that nets $30,000. Here are the potential retirement contributions you could make:

  • $16,500: the maximum amount to your 401(k) at work

  • $6,000: (20% of $30,000) to your SEP-IRA

  • $5,000: the maximum amount to a traditional IRA or Roth IRA

That’s a grand total of $27,500 in retirement contributions that come with fantastic tax benefits!

Should You Contribute to a SEP-IRA and a Traditional IRA?

If you read last week’s post, Should You Contribute to Both a 401(k) and an IRA?, you learned that some or all of your traditional IRA contributions may not be tax deductible when you or your spouse is covered by a retirement plan at work. A SEP-IRA is one of those employer retirement plans that may make you ineligible for traditional IRA tax deductions when you make over a certain amount. Be sure to read that article for more details about the income thresholds for each tax filing status. But this wouldn’t be a potential issue for Nadine because she’s contributing to a Roth IRA, not a traditional IRA.

What are the SEP-IRA Withdrawal Rules?

When it comes to taking money out of a SEP-IRA, the rules are generally the same as a regular traditional IRA. If you withdraw money before you reach age 59½, you’re typically subject to a hefty penalty of 10% and have to pay ordinary income tax on the distribution. You’re required to take taxable withdrawals once you reach age 70½. You can roll over your SEP contributions and earnings to a regular IRA or to another type of qualified retirement plan tax free.

How to Set Up a SEP-IRA

It’s easy to set up a SEP-IRA by completing Form 5305-SEP and opening the account(s) with a bank, insurance company, or other qualified financial institution, like ETRADE.com. Each account owner decides how to invest the funds in their SEP-IRA. You can put the money into most mainstream investments, like stocks, mutual funds, and money market funds. You’re always 100% vested in a SEP-IRA, which means that you own all the money in the account and can take it with you if you leave an employer or call it quits with your business. 

Using a combination of tax-advantaged accounts to save for your future is a smart way to make your investment dollars go farther and to make sure you’ll be sitting pretty with a cushy retirement fund.

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More Resources:
Publication 4333, SEP Plans for Small Businesses
Form 5305-SEP, Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement
SEP Frequently Asked Questions
SEP Resources on IRS.gov
IRA Resources on IRS.gov
IRS Employee Plans Videos

Image courtesy of Shutterstock

About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.