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What are SEP IRAs?

Adam Hill
Adam Hill

One of the several types of retirement accounts used in the United States is the Simplified Employee Pension Individual Retirement Account (SEP IRA). SEP IRAs are designed to specifically benefit small business owners and self-employed individuals. The main advantage to SEP IRAs is that there are little or no administration costs associated with these accounts.

When a self-employed person contributes to his SEP IRA, there is a certain dollar amount -- which can change depending on the tax year -- that he is allowed to put in. The restrictions on self-employed individuals are generally stricter than those on small business owners. The owner of a small business can contribute up to 25% of each employee’s pay to an SEP IRA for each employee. Whatever the level of contribution in a given tax year, it must be the same for all employees. SEP IRAs have no start-up costs and generally do not require the filing of forms with the government.

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To be eligible to participate, an employee must be at least 21 years of age and have worked for the employer in at least three of the last five years. The employee must also have received at least $500 US Dollars (USD) of compensation in each of the tax years in question. While SEP IRAs have a yearly contribution limit, they do not have a minimum yearly contribution. This makes them ideal for use by small businesses whose profits are cyclical in nature.

In practice, SEP IRAs are most frequently used by business owners without employees. Depending on the business structure, the business owner can contribute up to 20-25% of his salary on a yearly basis. Contributions to SEP IRAs are generally 100% tax deductible as a business expense. When a distribution or withdrawal is taken from an SEP IRA, that money is taxed as ordinary income, provided the withdrawal occurs after the account owner reaches 59.5 years of age. If a withdrawal occurs before that time, it is subject not only to income tax, but also a 10% early withdrawal penalty.

Establishing an SEP IRA involves just a few simple steps. First, one must contact a retirement plan professional, or a financial institution that offers these plans. This entity becomes the trustee of the IRA, meaning that it receives and invests contributions, as well as providing a yearly statement of the account value.

It is then necessary to complete and sign Internal Revenue Service (IRS) Form 5305-SEP, and to keep this form for reference rather than sending it to the IRS. If the account owner has employees, he would give a copy of this form to each employee. SEP IRAs may be established as late as the due date of the company’s income tax return for the year that the IRA is established.

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