Understanding SEP IRAs: A Comprehensive Guide for Business Owners

At O1ne Mortgage, we understand the importance of planning for the future, both for yourself and your employees. One of the most effective ways to secure a comfortable retirement is through a Simplified Employee Pension (SEP) IRA. This guide will walk you through everything you need to know about SEP IRAs, from their benefits to the steps required to set one up. If you have any questions or need assistance, don’t hesitate to call us at 213-732-3074.

What Is a SEP IRA?

A SEP IRA is a tax-advantaged individual retirement account designed for business owners and self-employed individuals. It allows employers to contribute to their employees’ retirement funds, as well as their own. Contributions to a SEP IRA are tax-deferred, meaning they can be deducted on your tax returns. However, distributions are taxable as regular income when withdrawn during retirement.

SEP IRA Basics

While SEP IRAs share many similarities with traditional IRAs, there are some key differences. Here are the basic rules for SEP IRA plans:

• You must open an individual SEP IRA account for each employee.
• All contributions are made by the employer; employee contributions and matching are not allowed.
• The contribution rate must be the same for all eligible employees.
• Contributions can vary from year to year.
• Contributions for the year should be made by the company’s tax filing deadline.

SEP IRA Contribution Limits

For 2023, the maximum contribution to a SEP IRA is $66,000 or 25% of compensation, whichever is less. The maximum amount of compensation that may be considered is $330,000. For 2024, these limits increase to $69,000 and $345,000, respectively. These limits are significantly higher than those for other types of IRAs, making SEP IRAs an attractive option for business owners and self-employed individuals.

SEP IRA Rules

The IRS has specific rules for setting up and maintaining SEP IRAs. Here’s a closer look at some of these rules:

Who Can Establish a SEP?

Businesses of any size, including sole proprietors, partners, corporations, and nonprofits, can set up a SEP IRA plan. Self-employed business owners who serve as their own sole employee are also eligible.

Eligible Employees

Employers can set up SEP IRA plans for their eligible employees, who must meet the following requirements:

• Age 21 or older
• Has worked for the employer for at least three of the past five years
• Is not covered by a union agreement
• Is not a nonresident employee without any U.S. source of wages, salaries, or other compensation
• Has received at least $750 in compensation

Self-Employment Contributions

Your SEP IRA contribution cannot exceed 25% of your compensation. For self-employed individuals, compensation is defined as net earnings from self-employment, minus half of your self-employment tax and any contributions made to your own SEP IRA.

Tax Deductions for Contributions

Contributions to a SEP IRA are tax-deductible, including those made to employees’ plans. However, the maximum deduction on your business tax return is the total amount of your contributions or 25% of compensation, whichever is less. Employees can exclude contributions from their gross income, and these contributions are not subject to federal tax withholding, Social Security, Medicare, or federal unemployment taxes.

Vesting

Contributions to SEP IRAs are always fully vested, meaning you and your employees have immediate access to the funds.

Income Taxes on Distributions

Withdrawals from SEP IRAs are subject to income taxes, and if you are under 59½ years of age, an additional 10% early withdrawal tax may apply.

SEP IRA Pros and Cons

SEP IRAs offer a middle ground between simpler individual IRAs and more complex 401(k) plans. Here are some pros and cons to consider:

SEP IRA Pros

• Higher contribution limits compared to traditional IRAs, Roth IRAs, and SIMPLE IRAs.
• Fewer complicated rules and filing requirements than many other employer-based retirement plans.
• Flexibility in contributions, allowing you to adjust based on your business’s financial situation.

SEP IRA Cons

• No Roth option, meaning contributions are tax-deductible, but distributions are taxable.
• Employee contribution rates must be equal, limiting flexibility in contribution amounts.
• All contributions are employer contributions; employees cannot contribute themselves.

How to Open a SEP IRA

If you decide that a SEP IRA is the right choice for you and your business, follow these steps to set one up:

1. Adopt a formal written agreement by completing and signing Form 5305-SEP, selecting an IRS-approved prototype SEP from your financial institution, or creating your own SEP plan document.
2. Provide each eligible employee with information about your SEP IRA plan.
3. Open a SEP IRA for each eligible employee through a brokerage firm, bank, credit union, or insurance company.

Ensure that you set up and fund your SEP IRA by the due date for your business’s income taxes to calculate and deduct contributions on your tax return. Contributions for future years are also due on tax day.

The Bottom Line

Whether you aim to save for your own retirement or help your employees achieve their retirement goals, a SEP IRA offers a straightforward way to make tax-deductible contributions with high IRS contribution limits. For solo business owners and entrepreneurs, SEP IRAs are worth considering. If you need assistance or have any questions, call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your retirement planning options.