A SEP-IRA is a tax-deferred retirement plan for self-employed people and small business owners. It can be a useful tool for saving for retirement. Like all retirement savings programs, though, there are limits, rules and regulations you need to know about to get the most out of your savings. While a good financial advisor can help you navigate the finer points of retirement account rules, we’ll walk you through the most important limits and rules you need to know.
SEP-IRA Contribution Limits
Unlike other retirement plans, employees do not make their own contributions to a SEP-IRA. Only the owner of the small business can make them for employees. Employees are often free to still contribute to a separate IRA or Roth IRA.
There are a couple of limitations when it comes to SEP-IRA contributions. An employer can contribute to an employee’s SEP-IRA up to either 25% of the employee’s compensation or $56,000, whichever is less. Up to $280,000 of an employee’s compensation may be considered. These contribution limits reflect the 2019 tax year and apply to both employees of small businesses and the self-employed. For 2018, the limit was 25% of earnings up to $55,000. For 2019, that increases to $56,000.
Those who have a Salary Reduction Simplified Employee Pension (SARSEP) plan that was established before 1997 were entitled to make elective salary deferral contributions. If you still have your plan, you can make elective deferral contributions up to $19,000 or 25% of your compensation, whichever amount is less.
It’s important to note that you cannot make elective salary deferrals or catch-up contributions to regular SEP plans. You also cannot contribute property to a SEP-IRA. All contributions must be made in cash. If you accidentally contributed more than the limits allow, visit the IRS website to learn how to correct the contribution mistake.
What Is a SEP-IRA?
A SEP-IRA is a retirement savings vehicle tailored toward self-employed workers and small business owners. A SEP-IRA is a traditional IRA under a SEP plan. “SEP” stands for Simplified Employee Pension. Essentially, a SEP-IRA serves as an easier way to save, tax-deferred, for retirement for small business employees and the self-employed.
It’s important to know whether you’re eligible to open a SEP-IRA. First off, you must be a sole proprietor, a business owner in a partnership or earn self-employment income. You may also open a SEP-IRA if you have a side gig that earns self-employment income.
SEP-IRAs provide a few advantages for those who can use them. For starters, SEP-IRA contributions qualify as tax-deductible business expenses. SEPs also tend to come with lower administrative costs than other retirement accounts. Plus, as an employer, you don’t have to contribute every single year. You contribute when it makes sense for your business, allowing for some flexibility.
You must start making required minimum distributions (RMDs) from your SEP-IRA by age 70 ½. If you make any withdrawals before age 50 ½, you’ll trigger a 10% penalty.
SEP-IRA Contribution Rules
You must make your SEP-IRA contributions by each year’s federal income tax due date. If you have a tax extension, you must make the contributions by the end of the extension period. If you miss the deadline, you cannot deduct any SEP plan contributions on that year’s return. You can deduct the contributions on the following year’s tax return. To report your contributions, you use Form 5498, shown here.
As an employer, you will need to make contributions to your employees’ SEPs proportional to each employee’s wages. Each employee will receive contributions of the same percentage. In the same vein, you must contribute the same percentage to your employees’ plans as your own. If you are self-employed, you will base your contribution on net profit, minus one-half of the self-employment tax.
You do not have to contribute to an SEP each year. When you do make contributions, though, you must make them for all eligible employees. You must also make a contribution even for a participant who is not employed on the last day of the year. An SEP cannot have a last-day-of-the-year employment requirement. Additionally, if an employee is over the age of 70 ½, they must still receive contributions if they are eligible. They will also be making withdrawals at that point.
Participating in an SEP plan does not necessarily limit you from making regular IRA contributions. You will have to make sure your SEP plan allows for it. If you are 50 or older, you may also make IRA catch-up contributions. Those contributions must still follow regular IRA contribution limits. These contributions may limit the amount of the regular IRA contribution that you can deduct on your income tax return, as well as the amount you can contribute to other IRAs like a Roth IRA.
SEP-IRA Tax Implications
When it comes to deducting SEP-IRA contributions on your business’ tax return, you can deduct up to the lesser amount of your contributions or 25% of your compensation. Employees are not subject to taxes according to their employer’s contributions. This is because SEP-IRA contributions are not included in an employee’s gross income. If you are self-employed, the IRS has different steps to figure out your own maximum deduction.
If you make excess contributions to a SEP-IRA, then those are considered part of an employee’s gross income. To avoid a tax penalty, you will have to withdraw that excess amount before the due date of your federal tax return. Should you fail to make the withdrawal on time, you’ll face a 6% tax on the excess contributions. In addition, the employer may face a 10% excise tax on the excess amount.
To reap all the tax benefits of a SEP plan, you’ll have to meet all of the IRS’ requirements. If you make any mistakes regarding contributions or withdrawals, you’ll lose out on those tax benefits. However, the IRS does leave room for you to correct any mistakes before your federal tax return due date.
The Bottom Line
A SEP plan allows small business owners and the self-employed to participate in structured retirement accounts. It’s always important to keep up with account contribution limits, SEP-IRAs included. This way, you can make the most of your IRA, but also avoid some big tax hits. Luckily, if you do accidentally make an excess contribution, the IRS allows you some time and options to reverse it.
Tips for Saving for Retirement
- It’s incredibly important to take advantage of your company’s 401(k) offerings if available. That way, you can set the contribution limit and forget it, instead of worrying about contributing to an IRA.
- Without a huge and steady income in retirement, you might be worrying about how much of a tax hit you’ll see each year. Further, your tax hit will depend on where you choose to retire. Check out this tax-friendliness calculator to determine where you can pay less taxes in retirement.
- Whether you’re a business owner or an employee, a financial advisor can be a big help in organizing your retirement accounts. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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