SEP IRA Rules And Contribution Limits: Retirement Plans For Self Employed People

In the past couple of years I've been considering taking a chance and becoming a self employed entrepreneur, and something I've had to consider is how I'll be saving for retirement.  As a self employed person, you won’t have the option of a 401k.  You do have some other options though. Among them:

• SEP IRA
• SIMPLE Plan
• Solo 401(k)
• Keogh Plan

In this post I'll be exploring one of the more attractive options for tax deferred investing for self employed individuals, the SEP IRA

What Does SEP IRA Stand For?

Before we get too far we need to set out the basic definitions.  So what does SEP IRA stand for?  I assumed it meant something like “Self Employed IRA”  because I had encountered this type of account when reading about being self employed.    SEP IRA actually stands for Simplified Employee Pension Individual Retirement Arrangement.   The SEP IRA was intended as a plan for small businesses to set up a retirement plan for their employees without al lot of hte administrative and paperwork costs normally associated with retirement plans.

The SEP IRA is similar to a traditional IRA account.  The biggest differences come when you talk about the contribution limits.  The contribution limits for a SEP IRA are higher.

Rules For The SEP IRA

As an employer opening a SEP IRA for your business is subject to rules and regulations.   SEP IRAs have a lot of the same rules as a Traditional IRA.  Among the SEP provisions:

• All eligible employees must be provided with plan benefits, and a separate IRA account.   If you are self employed with no employees besides yourself, it isn’t an issue. If you have employees, it is something to consider.
• Part time employees who are 21 years of age who have worked 3 out of the preceding 5 years, earning $500 or more annually will be eligible.
• Only the employer can contribute to the SEP IRA.  If you work for a company that provides one, only your employer can contribute to the account.
• You have until the tax filing deadline of April 15th to establish and fund your SEP IRA.
• Withdrawals from a SEP IRA are treated the same as withdrawals from an IRA account – with a 10% early withdrawal penalty, and taxes charged at your current rate.
• Only income from the business can be contributed.  If you have a day job as well, that income can't be contributed.

Contribution Limits For The SEP IRA

Contributions to the SEP IRA are subject to yearly limits, however, they are higher than many other similar account types.

For example, for tax years 2010 you can contribute up to 25% of an eligible employee’s compensation, up to a limit of $49,000.  Extrapolated from the 25% rule the income threshold for a SEP IRA is then $196,000.

Example: Let’s say you make $100,000 a year and you’re self employed.  Under a SEP IRA you would be able to contribute 25%, or $25,000 to your plan.

Older employees are not allowed catch up contributions.

Pros Of The SEP IRA

There are quite a few reasons to consider having  a SEP IRA account:

• Any money that is contributed by your employer (you if you're self employed), you are 100% vested in right away.  The money is yours!
• Your money grows tax free until retirement!
• Contribution limits for self employed individuals are higher than similar plans.
• Setting up a SEP IRA is usually as easy as filling out IRS Model Form 5305-SEP
• Administrative costs and paperwork are minimized after the plan is setup.
• Contribution levels are flexible.  A good plan if cash flow for your business is variable.  You can contribute 5% one year, and then 20% the next if you want.

Do you have a SEP IRA that you contribute to? If so, how do you like it so far?  Are there any bad points about the plan that you don't like, or benefits that we didn't mention? Tell us your thoughts in the comments!