Follow this link for information on Traditional and Roth IRA contribution limits.
SEP-IRA – it’s not just for the self-employed
Have you been considering ways to make additional income or perhaps even embark on a journey of self-employment and financial independence? Assuming you have already considered the Risks and Rewards of Entrepreneurship there remain a few nagging questions for the would-be entrepreneur… not the least of which is, “How do I save for retirement without a 401K?”
This week we will consider one answer to that question: the SEP-IRA. First things first; “SEP-IRA” is an acronym for Simplified Employee Pension IRA not Self EmPloyed IRA. The descriptive name gives us a decent clue of the primary purpose for its existence. The SEP-IRA was designed as a low cost solution for allowing small businesses to provide employees with a pension without shouldering the high administrative costs of 401k’s and defined benefit plans. When an employer contributes to a SEP-IRA, the money goes into an IRA owned and managed by the employee. While there are both positives and negatives to this arrangement for an employer, we are primarily interested in the option this provides the self-employed.
SEP-IRA contribution limits
For employees:
One of the primary benefits of a SEP-IRA is that it has a high contribution limit. The 2009 and 2010 contribution limits for eligible employees are the lesser of either $49,000 or 25% of total employee compensation.
Example: Your employee earned $50,000 for 2009. The maximum contribution you can make to their SEP-IRA is $12,500 (25% x $50,000).
For self-employed:
Contribution limits for the self-employed are not quite as straight forward but, barring limits, are approximately 18.6% of net profit. For exact computation tables see section 5 of IRS Publication 560.
Only income from the business can be contributed – you can’t contribute money from your day job. Also, an adjustment is necessary to account for their ability to deduct both FICA taxes paid, and contributions to their own SEP-IRA, both of which count toward their maximum deductible income for the year.
SEP-IRA participation limitations
While the SEP-IRA may be an excellent option for some self-employed individuals, the IRS does set limitations as to who can participate. Specifically, one cannot fall under the definition of a “common-law” employee. According to the IRS:
“A common-law employee is a person who performs services for an employer who has the right to control and direct the results of the work and the way in which it is done.”
A particular indicator is the employer’s ability to fire the employee. This is true even for some workers who the IRS classifies as indeed having “self-employment income” for the purpose of social security, such as insurance sales workers. These are not exclusive classes however. A person can be a common law employee by day and a SEP-IRA qualified sole-proprietor by night, but the difference must be clearly understood (and documented) as only income from the qualifying business may be contributed to a SEP-IRA.
Contribution deadlines and other final details
In addition to all the requirements discussed above, most of the same rules that govern traditional IRAs also apply to SEP-IRAs. Specifically the minimum, no-penalty withdrawal age of 59-1/2, and the required minimum distributions beginning at age 70-1/2. Since the money contributed to a SEP-IRA is pre-tax, distributions will be taxed at whatever rates are in effect for your bracket during the year of distribution.
As a final consideration, the IRS does not allow a loan to be taken out against the remaining account balance. This common feature of 401k plans provides a semi-liquidity option many have come to expect, the absence of which should be considered before large sums are contributed. The contribution deadline for previous year SEP-IRA contributions is the same as your yearly tax return deadline, including extensions. That means it is not too late for those with small businesses to lower their 2009 taxable income by contributing to their SEP-IRA!
Of course, the SEP-IRA is not your only option; here is a good comparison of SEP vs. solo 401k.
What do you think?
Do you have a SEP-IRA, want a SEP-IRA, or have more questions about SEP-IRAs in general? Let us know in the comments.
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{ 14 comments… read them below or add one }
Solid post! Congrats on the DFA Staff Writer position, Robert. Looking forward to more posts from you!
The SEP-IRA is an often overlooked option for business owners trying to stash a little more away without the added costs and reporting!
Great informative post Robert – excellent writing. I look forward to more great posts!
Question.. I wasn’t 100% clear on if you have to be completely self employed to have one of these accounts, or if you can simply have a side business in addition to your day job – and contribute to one of these?
Thanks!
Good question Pete. According to IRS Publication 560:
Peter,
The only catch is you can only contribute Self-Employment income to your SEP. Money from your day job must be saved in an employer’s 401k, or a ROTH/TIRA.
Good informative post, Robert. I look forward to more of your writing each week.
Robert. Nicely done. You may find yourself in the running for the Pilgrim Pick of the Pack one of these days…soon.
Robert, this is a very prestigious award… I wish you the best of luck!
Very informative post, Robert! I’m torn between continuing to contribute to my 401k at my full-time gig or going with a SEP or Solo 410k plan. Unless things really take off, it looks like I can save more by maxing out my 401k at work, but that could change. Thanks for providing some specific numbers so I can run through these calculations.
Since 19% is a pretty small amount compared to, say, a SIMPLE IRA or a 401k, is it allowed to contribute to both a SEP IRA and a regular IRA at the same time?
You can contribute to a TIRA or 401k, but the IRS will only let you defer so much income a year. So you can spread the money between different accounts, but it won’t raise your contribution limit (remember, the lower limit is because a self employed person is also deducting FICA). If you want to save more, you can put an additional $5k/year into a ROTH IRA and enjoy the tax advantage on the other end.
Wow, I had forgotten how high the contribution limit was for the SEP. Now if only I had that much to put in there
Thanks for the writeup Robert!
Adding this to my resource pool for breaking free from the man. Awesome information, great out of the gate Robert!
question:
i am self employed and as a result of a large fee i will earn in one shot 90k
my wife is working for a boss with no retirmement at all . her income is 48k
until now we only put in ira. but a sep ira + ira might be the best way to go
estimated total income for 2010 is 135k
we pay our own health plan.
max for sep ira
max for ira
max for health savings plan
How much approximately can i put away for h and w in total for a sept ira or a combined sept ira & an ira
thanks
joe f
Hey Joe, sounds like you could do $10,000 in a traditional IRA ($5k for each of you) and to figure your limits for the SEP contribution simply follow the calculation tables/worksheets in IRA publication 560.
Simply open the .pdf file, and scroll down to section 5 (page 22) and follow the worksheets. According to the IRS your contribution will probably be around 18.6% of your net profit.
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