Intro: Sep IRA Rules | Guide | SEP Withdrawal, Contributions, and Plan Requirements
Many pragmatic people thinking about their retirement may be asking about SEP IRA rules. In particular, people want to know what the SEP IRA plan rules are in their entirety.
SEP IRAs (Simplified Employee Pension Individual Retirement Arrangement) are becoming widely popular among business owners and self-employed individuals for certain reasons: SEP IRA plans offer plenty of long-term profits and flexibility to business owners and their employees as well as self-employed individuals.
To appreciate the finer details of SEP IRAs, this article will investigate the particular SEP IRA contribution rules, SEP IRA withdrawal rules, and SEP IRA distribution rules. By doing so, this article will show why an SEP IRA is a prevalent choice among business owners. But first, let’s define what they are.
Just What Are SEP IRAs?
An SEP IRA is way for small business owners (and we mean small businesses – SEP IRA rules allow for a business owner with only one employee to open an SEP IRA) to contribute a percentage of an employee or employees’ compensation to an IRA.
According to SEP rules, employees do not contribute – only the employers. Also, these contributions are tax-deductible for both the employees and the business owners – which is one of the main incentives for using an SEP IRA.
Self-employed individuals can open SEP IRAs as well, but, as we’ll see, the SEP IRA rules are slightly different for business owners and self-employed individuals – that is, the SEP rules for max contributions that business owners and self-employed individuals can make are different.
SEP Rules for Applicability
According to the SEP rules, when it comes to small businesses, there is one main requirement: all employees who qualify must be included. There are three main SEP IRA rules listed on the IRS’s website, which we will list here:
- Employee has attained 21 years of age
- Employee has worked for the business for three out of the last five years
- Employee has received at least $600 in compensation
These SEP plan rules are not overly complicated. Also, employers can lower the eligibility requirements if they want to include more employees in their SEP IRA plan. For example, business owners can lower the age requirement to 18 years of age or the work requirement period to only three months of service.
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A business owner may even set a single age requirement to determine his or her employees’ eligibility.
SEP rules allow for such easy manipulation of the eligibility requirement, which adds to the overall flexibility. However, SEP IRA rules state that such requirements must be extended to all employees.
On the other hand, let’s consider the SEP plan rules for a business owner who doesn’t want to actually include all employees. This business owner, according to SEP rules, would have to include employees who meet the three bullet points listed above. In short, SEP IRA rules dictate that employers may set less restrictive requirements than those listed above – but employers cannot set requirements that are more restrictive.
According to SEP IRA rules, self-employed individuals have the same eligibility requirements as those listed above.
Next, let’s look at the SEP contribution rules; as we’ll see, the SEP IRA contribution rules are different between the two groups – that is, business owners and self-employed individuals.
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SEP IRA Contribution Rules
For employers of small businesses, the SEP rules for maximum contribution are the following:
- 25% of the employee’s compensation, or
Essentially, whichever amount is the lesser applies.
For self-employed individuals, the SEP IRA contribution rules for the maximum limit end up being slightly different; this is due mostly to the Federal Insurance Contributions Act.
In essence, the SEP plan rules for the max contribution limit for self-employed individuals turns out to be about 18.6 percent of net profits.
In general, the cool thing about the SEP IRA contribution rules is that they allow greater monetary amounts than other IRAs. Here’s a simple list of the contribution limits for other IRAs:
- Traditional: $5,500 (or $6,500 if you’re over 50 years of age)
- Roth: Same as traditional IRAs
- 401(k)s: $18,000
- SIMPLE: $12,500
Clearly, SEP contribution rules allow for much higher contributions.
On top of the SEP rules for higher contributions, business owners or self-employed individuals have great flexibility in how much they may choose to contribute.
Each year, business owners or self-employed individuals can choose whether to contribute or not and at what percentage, and this flexibility helps them adjust accordingly for productive years versus years of poor performance.
The SEP IRA contribution rules allow flexibility in due dates as well. Contributions can be made at the “last minute” for a given year, where SEP rules only require that contributions are due at the same time as tax returns, which is April 15 for most people.
It must be noted, however, that if a business owner decides to contribute, the SEP plan rules dictate each of his or her employees must receive the same percentage – that is, all employees (along with the business owner) must receive the same percentage.
The SEP IRA contribution rules do not allow for anyone to be left out. For example, business owners cannot contribute 20 percent for one employee, zero for the next, 15 percent for the third, and 25 percent for himself or herself in a given year.
Next, we’ll look at how taxes work for SEP IRAs.
SEP IRA Rules for Taxation
According to SEP IRA rules, self-employed individuals’ and business owners’ contributions are not taxed when they are made. Instead, SEP IRA funds are taxed when they are withdrawn. This allows for contributions to compound tax-deferred for many years.
What’s more, SEP IRA rules state that contributions are tax-deductible for business owners and self-employed individuals, and this fact affects taxes overall in several ways.
In short, these contributions add deductions which lower taxable income, causing a business owner’s or self-employed individual’s tax calculations to be lower in response.
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According to SEP IRA rules, self-employed individuals’ contributions are deducted from his or her adjusted gross income (AGI). Lowering AGI can help an individual attain other tax breaks. For example, having a lower AGI leads to a reduced federal income tax.
For businesses, SEP IRA contributions count as a business expense which lowers net profits and in turn income tax.
The concept of tax deferral needs special attention because it opens up possibilities for savings and profits. Deferring taxation to the withdrawal stage allows the currently saved money to be reinvested in a business’s urgent needs. What’s more, tax-deferred compounding results in the various SEP IRA accounts, through many years, to build up a bigger balance.
Through using SEP IRAs to defer taxes, people can move their present tax liabilities to sometime in the future. When income is situated for future dispersal, people can control their income level by choosing how much they receive from their SEP IRAs. By doing so, individuals can in turn control their tax levels.
Essentially, in regard to SEP IRA rules, self-employed individuals and business owners should make contributions when they are in higher tax brackets.
Then, later on, these same groups should disperse their SEP IRA accounts when they are in lower tax brackets. Completing both aims would result in the most saved money, in regard to taxes.
When SEP IRA funds are withdrawn during the appropriate time frame (age 59 ½ and older), SEP IRA rules dictate that the funds are to be taxed as ordinary income.
SEP IRA Withdrawal Rules, Before Age 59 ½
The SEP IRA withdrawal rules for the early removal of funds – those taken before age 59 ½ – state that a penalty fee will be applied, which is 10 percent of the withdrawn amount.
However, the IRS does allow for exceptions from this penalty fee in its SEP withdrawal rules. The following list is taken directly from the IRS’s website.
- You have unreimbursed medical expenses that are more than 10% (or 7.5% if you or your spouse was born before January 2, 1951) of your adjusted gross income.
- The distributions are not more than the cost of your medical insurance due to a period of unemployment.
- You are totally and permanently disabled.
- You are the beneficiary of a deceased IRA owner.
- You are receiving distributions in the form of an annuity.
- The distributions are not more than your qualified higher education expenses.
- You use the distributions to buy, build, or rebuild a first home.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
Let’s take a look at a few of these exceptions in the SEP IRA withdrawal rules. In regard to first-time home buying, certain costs and purchases allow for the exemption of the withdrawal penalty. However, the SEP rules enforce a limit of $10,000, where any amounts withdrawn after the original $10k will suffer the 10% penalty.
If you have a spouse that also has a SEP IRA, he or she can also withdraw $10,000 penalty-free, according to the SEP IRA withdrawal rules. Funds withdrawn from SEP IRAs for home-related purchases must be spent within 120 days.
For medical expenses, the SEP IRA rules allow for penalty-free early withdrawals if the medical bills account for more than 7.5 percent of the relevant individual’s adjusted gross income.
For health insurance, SEP withdrawal rules say that individuals who have been unemployed for 12 weeks or more can use their SEP IRA funds penalty-free to pay their health insurance premiums – not only for themselves, but also for their spouses or dependents.
If an individual becomes disabled, SEP IRA rules allow for early tax-free withdrawals. If an individual with a SEP IRA passes away, his or her beneficiaries can withdraw the funds penalty-free, according to SEP rules.
In regard to higher education, many types of schools apply. The amount of the SEP IRA funds that can be withdrawn penalty-free will be the amount of the expenses paid for the higher education institutions in the same year.
SEP IRA regulations state that these expenses qualify: fees, supplies, books, tuition, and equipment – such things that are needed by a person for the sake of attending a particular institution. Also, SEP withdrawal rules allow for special needs services to qualify as well as room and board.
SEP IRA Withdrawal Rules, After Age 59 ½
SEP rules say that once an individual reaches the cutoff age for penalty-free withdrawals, 59 ½, the only thing his or her withdrawals will suffer is typical income tax rates. What’s more, the SEP IRA distribution rules allow people to take their full balance all at once, or they can distribute their balances in payments.
However, individuals need to be careful when they reach age 70 ½, as this is when the SEP IRA distribution rules enforce the required minimum distributions (RMDs).
SEP IRA rules make it mandatory for individuals to start withdrawing funds at 70 ½. If they do not, the SEP withdrawal rules apply a whopping 50 percent penalty fee on what they should have paid – which is their RMDs. The IRS provides a worksheet for calculating RMDs.
So, in short, the SEP IRA distribution rules don’t want you to forget about your hard-earned cash!
How Hard Is It to Manage SEP IRAs?
As it turns out, SEP IRAs are quite popular because they are easy to set up and have low to no fees. For example, Fidelity charges its customers no annual fees or establishment fees for their SEP IRAs. The only fee the company takes is $7.95 for online U.S. equity trades.
The IRS provides basic SEP IRA rules for getting an account started. The employer will come up with a formal agreement, which can be either the IRS’s 5305-SEP or IRS-approved documents provided by banks or other qualified institutions. Then each employee must agree to the plan.
Once the form is properly filled out and accepted, each employee will own his or her SEP IRA, and the employer will get to make contributions each year as he or she sees fit. The SEP rules allow that employers may even choose to not contribute for a particular year.
People who wish to set up SEP IRAs for themselves or for their employees can do so very late. SEP IRA rules provide a late deadline for setting up and contributing to an SEP IRA: the end of the tax season. Also, SEP rules allow for an individual to have an SEP IRA and other retirement plans at the same time.
Conclusion: SEP Rules
As we have seen, SEP IRAs are a worthy consideration for small business owners or self-employed individuals. The SEP IRA plan rules definitely establish flexibility and potential savings in tax deferment, which are characteristics that stand out.
The SEP rules provide flexibility in contributions – SEP IRA contributors, whether business owners or self-employed individuals, may contribute (or not) whatever amounts they feel they can manage for a particular year.
The contribution limits of SEP IRA rules stand out as well. When it comes to IRAs, SEP rules provide some of the highest contribution limits, which add to the overall flexibility.
In addition, the fact that contributions are tax-free and can be written off as tax deductions are key points. When business owners or self-employed individuals save on present taxes, they can then reinvest that saved money where their businesses need it.
On top of all the potential benefits, SEP IRAs are easy to set up, having only a few steps that need to be taken, and most financial institutions do not charge anything for SEP IRA setups or maintenance.
With the potential flexibility, long-term savings, and hassle-free maintenance, business owners and self-employed individuals should take a moment to seriously consider opening SEP IRAs.
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