Starting your own business takes some serious hard work. And one of the last things entrepreneurs think about, especially in the first few years, is planning for their retirement. With all of the thousands of things going on right now, retirement seems way out of the picture and too much to deal with. But it’s never too early to start saving for your future, and small business retirement plans aren’t all complicated. The easiest option in my opinion is the SEP-IRA. So what is a SEP-IRA? A Simplified Employee Pension Plan. Read on for SEP-IRAs key features and retirement benefits for entrepreneurs and employees.
Reasons To Open A SEP-IRA
- Similar to a profit sharing program
- Flexibility: contribution amounts can vary from one year to the next
- Very minimal paperwork, no IRS filings
- Low cost or even free to open an account
- Flexibility in how funds are invested (same as any other IRA)
- Tax savings
- Contributions are 100% vested right off the bat
- Save for your own retirement
- Plus easily provide retirement benefits to current and future employees
Who Is Eligible:
SEP-IRAs offer retirement benefits for entrepreneurs and employees. More specifically, sole proprietors (ex. Schedule C tax filers) as well as business owners and their employees are eligible. Business owners must establish their own employee eligibility requirements (within the set government limits below) at the start of offering SEP-IRAs. They do so by filling out IRS form 5305-SEP, which takes less than 5 minutes to fill out, and doesn’t have to be sent in to the IRS, but has to be filed in the company records.
You may chose to offer SEP-IRA benefits to employees as early as their first day of hire if you wish. But, most employers will probably want their employees to pass a probationary period of some sort first. The government requires that the same benefits and eligibility requirements are applied to all employees, and are no stricter than:
Age: 21 and older
Length of employment: 3 of the last 5 years
Compensation level: $500 or more for the tax year
- Contributions are deductible and are not subject to federal income tax withholding, social security, Medicare or federal unemployment (FUTA) taxes. (Employees don’t deduct b/c the contributions are excluded from gross wages)
- Earnings are tax deferred
- Qualified withdrawals after age 59 1/2 are taxed at ordinary income levels
How Much Can You Contribute To A SEP-IRA?
In order to determine how much can be contributed to a SEP-IRA each year, you have to be a sole proprietor or a business owner (not an employee). This may sound a bit strange that employees don’t get a say, but it’s really not that complicated.
CORPORATIONS: Let’s start with corporations, as they are more straight forward. If you think about SEP-IRAs like profit sharing they are easier to understand. An employer must follow these contribution rules:
- A percentage of compensation between 0-25% to contribute to all employee plans every year
- All eligible workers must receive the same percentage
- Contributions are based on the first $255,000 (2013) of compensation per employee
- And there is a $51,000 max per employee (2013).
Let’s say ACME Corp has 2 employees who make $50,000 (David) and $75,000 (Katie) respectively. Last year in 2012, business wasn’t that great so ACME Corp only allocated 5% towards the employees’ SEP-IRAs. David received $2,500 into his account ($50,000 x 5% = $2500) and Katie received $3,750 into hers ($75,000 x 5% = 3,750). Keep in mind the contribution amounts are fully funded by ACME Corp, not David and Katie, and these are in addition to the employee’s existing salaries. So David received his annual salary of $50,000 plus an additional $2,500 into his SEP-IRA account. Neat!
Continuing our example, let’s say ACME is now having a banner year in 2013 and have decided to pay out 25%! David will now receive $12,500 ($50,000 x 5% = $12,500) and Katie will receive $18,750 ($75,000 x 5% = $18,750). That’s quite a nice retirement benefit! David and Katie are happy because they can collect their full salaries, they can easily invest their SEP-IRA funds into the markets, and they don’t even have to file any tax forms for the money that was funded into their accounts! ACME Corp is happy too because the employees are receiving benefits, and the corporation can deduct those contributions each year and pay less taxes.
SOLE PROPRIETORS: Sole proprietors work for themselves and typically don’t have any employees. The great news is they are still eligible for SEP-IRAs. You just have to think about the contribution process a little bit differently. If you’re a sole proprietor, you have to look at your net business profit (the total revenue of your business minus all expenses from Schedule C, C-EZ, or K-1). The main reason calculating contribution amounts is a bit confusing for sole proprietors is because of FICA taxes and because you’re a owner/employee as one. The limit for contributions comes out to roughly 18.6% of net profits.
The percentage range of 0-25% of compensation still applies but it’s not as straight forward a number as it is for employees of corporations. In other words, “compensation” for a sole proprietor is calculated by taking your net earnings from self-employment and subtracting half of your FICA taxes and the contributions to your SEP-IRA.
Let’s say Jill is a sole proprietor who had $50,000 in net profits last year. Half of her FICA taxes was $3,532. If you take the difference in those numbers you get $46,468. Then times that by 20% which gets to the max contribution Jill could set aside last year of $9,294. There are free calculators out there that will do the math for you if you know your net profits, so don’t worry about over thinking things.
Steps To Open A SEP-IRA Account
- Fill out IRS Form 5305-SEP for your corporate records. You don’t have to actually file or mail it to the IRS.
- Notify your employees of your company’s eligibility requirements (stay within the government guidelines)
- Instruct your employees to open their own individual accounts (can be as easy as answering a few questions online. I recommend Fidelity.com).
- Collect your employees’ account numbers and information.
- Determine how much your business can/wants to contribute to employees for the year (you have until April 15 for the previous tax year).
- Fund your employees accounts (can be as easy as writing a physical check or sending funds electronically)
- Inform your employees their accounts have been funded.
- Keep track of the total contributions paid. Corporations should record this amount as an expense for tax benefits.
* Manage Your Finances In One Place: The best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month. The best tool is their Portfolio Fee Analyzer which runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying! There is no better financial tool online that has helped me more to achieve financial freedom. It only takes a minute to sign up. You can also try out their new retirement calculator!
Untemplaters, I hope you’re now more familiar with the SEP-IRA retirement benefits for entrepreneurs and employees. Did you know what is a SEP-IRA prior to reading this post? What types of retirement accounts do you currently hold?
Copyright 2013. Original content and photography authorized only to appear on Untemplater.com. Thank you for reading!
Bryce @ Save and Conquer says
I really like SEP IRAs. We had that at our company until we grew to be larger than 50 employees. Back in the 90s, companies with more than 50 employees were not eligible for a SEP IRA plan, and needed to implement a 401(k). From reading the latest IRS FAQ on SEPs, it appears that is no longer the case. I’m glad to see that has changed.
Nice to hear from someone who has had positive first hand experience with SEP-IRAs. I didn’t realize they used to have a restriction on the number of employees for offering the plan. It’s nice to hear that the government has done at least one thing towards less regulation lol.
Chuck@Tortoise Banker says
Do you recommend an individual 401k for someone without any employees, or a SEP IRA?
Self-Employed 401K plans are another good option if you work for yourself and don’t have any employees to worry about. There’s a little more paperwork involved but most of the same benefits. If you are only working for yourself part-time on the side and still have a day job, I’d recommend going with the SEP-IRA. Depending on your tax situation you may be able to benefit from a traditional 401K plus a SEP-IRA on top of that.
Financial Samurai says
Nice research Sydney! Contributing 25% of pay up to ~$50,000 sounds pretty sweet. Gotta make $200,000 first though… which coincidentally is my ideal income for max happiness!
It’s too bad one has to make money (and therefore pay taxes) in order to save 25% in a SEP-IRA. At least 25% is better than nothing! Gonna get on this one.