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What Is a SEP IRA, and Why Is It Important to You as a Business Owner?

Updated: Nov 17, 2021

The following article is strictly the opinion of the author and is to not be considered financial/investment advice. Call to Leap LLC and the author of this article does not claim to be a registered financial advisor (RIA) or financial advisor. Please visit our terms of service and privacy policy before reading this article.

What if there was a retirement account that could set you up so well that you won’t have to worry about inflation? Or unpredictable medical expenses? Or a recession?

If you own a business or plan to own one in the future, you might want to consider opening this retirement account that can make you so comfortable during retirement that you won’t have to worry about any of that stuff.

Introducing the SEP-IRA. AKA the Roth IRA’s cool, distant cousin who gives you tax-benefited retirement funds.

After reading this article you’ll have a clear understanding of:

  • What a SEP IRA is.

  • The rules for SEP IRA.

  • How to open a SEP IRA.

  • How to start investing in a SEP IRA.

The rules for SEP IRA - What is it and how does it work?

SEP IRA stands for Simplified Employee Pension Independent Retirement Arrangement.

What the heck does that even mean?

Like a traditional IRA, a SEP IRA is a retirement account that allows you to make pre-tax contributions. You can also invest your contributions into securities like stocks, bonds, ETFs, and more. But unlike the Roth IRA, the SEP IRA is only available for self-employed individuals.

With a SEP IRA, contributions are “tax-deferred” meaning that taxes are only taken when you withdraw your money out of your account after age 59½. The benefit of this is that your money is going to grow at a faster rate because you’re putting it into your IRA without taxes. In other words you have more money to invest when you don’t pay taxes on it. The only “downside” is that you pay taxes when you withdraw your money during retirement.

That might sound a little confusing so let’s go over an example!

Let’s say you want to contribute $10,000 of your hard-earned money from your business into your SEP IRA. You can put the $10,000 into your SEP IRA tax free. And this money will grow because you invested it in something.

If you were to invest your money without a SEP IRA, then you would first have to pay taxes on your earnings before you invest it. So, if the income tax rate is at 10% on your $10,000. Then you would have $9,000 to invest instead.

If you decide to take your distributions (money from your IRA account) out before age 59½, you may be subject to penalty fees.

If you’re a business owner, one perk of having a SEP IRA is that your contributions are tax-deductible.

In English, that means whatever money you put into your SEP-IRA for the year will count as tax-deductible. This means that you can subtract that amount from your total income for that year. An example of this would look like this: If you made $70,000 and you made a $20,000 contribution into your SEP-IRA, then you’ll use the number $50,000 to determine what tax bracket you fall in.

Who is eligible for a SEP IRA?

SEP IRAs are for self-employed or small-business owners with few to no employees. If you have a SEP-IRA for your small business, it’s important to remember that your employees are eligible for contributions from your company into their IRA.

To qualify for contributions from your SEP IRA, your employee must meet the following criteria:

  • They must be at least 21 years or older.

  • They must have worked with you for three of the past five years.

  • They must have earned at least $600 from you in the past year.

If your employee meets the above criteria and you have a SEP-IRA for your business, you must contribute an equal percentage of compensation to your account and your employee’s account according to the IRS.

So if you want to contribute 10% of your earnings for the year into your SEP-IRA, you’ll have to contribute 10% of that employee’s earnings into their plan as well.

Because of these rules, SEP IRAs are ideal for self-employed individuals or small businesses with little to no employees.

How do I start my SEP IRA?

Open an account

With today’s technology, there are plenty of reliable account providers online. You can choose to research online SEP-IRA account providers, or you can even use your bank in some cases.

After you’ve decided who you want to use for your account, the IRS requires the following three steps:

  1. Create a formal written agreement. You can do this either with your account provider or with the IRS.

  2. Give your eligible employees information about the SEP-IRA.

  3. Setup separate SEP IRA accounts for your employees with your account provider.

Invest in your SEP IRA

Just like a Roth IRA, the SEP-IRA allows you to invest in stocks, bonds, ETFs, mutual funds, etc. Keep in mind that your options may be limited depending on what account provider you have.

For example, you can choose to open your SEP IRA with a bank. But some banks only allow you to invest your SEP IRA contributions into certificates of deposit which typically gives you a lower ROI than stocks or ETFs.

Deciding what to invest your SEP IRA contributions in can be a bit time-consuming when you think about all of the options you have. Some things to keep in mind to narrow down your decision-making process are your risk tolerance, when you want to retire, and how long you have until retirement.

Why would you want a SEP IRA?

Okay, we just threw a ton of information at you.

But let’s break all the info down and weigh out possible reasons why a SEP IRA might be the right move for you.

If you don’t have a 401k

Many small businesses are not able to give their employees a 401k. In this case, the SEP-IRA can be used to give your employees a retirement plan.

But remember that you’ll have to contribute an equal percentage of earnings between you and your employees. So the SEP IRA may only be ideal if you have less than a handful of employees.

Contribution limits for SEP IRA

Both the Traditional IRA and Roth IRA have a contribution limit of $6,000 per year as of 2021.

But the contribution limit for the SEP IRA is 25% of your earnings up to $58,000 a year as of 2021.

In other words, the SEP-IRA allows for a much larger contribution limit compared to its not as cool IRA relatives.

What now?

If you or anyone you know is a business owner, you can definitely benefit from the information in this article and set yourself up for a successful retirement.

Opening a SEP-IRA is a great replacement for a 401k since you won’t have another retirement plan that covers yourself and your employees.

Keep in mind that you can have both a SEP IRA and Roth IRA at the same time. So if your business is in its early stages, you don’t need to rush to get both right away.

Take your time deciding whether or not the SEP-IRA is the right step for your business. It will take time to research what to invest in, what account provider you want, and the rules for the SEP IRA.

If you’d like to learn more about different types of retirement accounts, check out our article “Different Retirement Account IRAs Explained & Pros and Cons.”

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