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A Simplified Employee Pension (also known as a SEP IRA) may help you save money on your taxes if you are self-employed.
For many small business owners and self-employed persons, taxes are a primary concern. Contributions to a SEP IRA lower your taxable income to the IRS. They can be made up until you file your taxes (so in theory up until April 15th).
Your money will grow tax differed while it is in the SEP IRA and will be taxed when you withdraw the dollars in retirement.
IRS Definition
According to IRS website publication 560:
A Simplified Employee Pension (SEP) is a written plan that allows you to make contributions toward your own retirement (if you are self-employed) and your employees’ retirement without getting involved in a more complex qualified plan. Under a SEP, you make the contributions to a traditional individual retirement arrangement (called a SEP-IRA) set up by or for each eligible employee. A SEP-IRA is owned and controlled by the employee, and you make contributions to the financial institution where the SEP-IRA is maintained.
What this means is…
If you are a self-employed person you may make contributions to your SEP IRA and choose where you invest the money. Choice along with deductibility is a key attractive feature of the SEP IRA.
Effect on Taxes
The contribution limits for a SEP IRA are very high compared to most retirement saving options.
A SEP IRA will allow you to deduct the lessor of the following two amounts:
- Up to $44,000 for tax year 2006
- Approximately 25% of your self-employed income
If you are in the 28% income tax bracket and fully fund your SEP IRA, that would be a tax savings of $12,320.
Matching Requirements
If you are self-employed but have W-2 employees, a SEP may not be right for you. While SEPs have high contribution limits they also have high matching requirements.
You will be required to put the same percentage in all your employees’ SEP IRA’s that you contribute into your own.
For example, if you contribute 15% of your income to a SEP, then you will also be required to contribute 15% of each employee’s salary to their SEPs regardless of whether or not they actually make their own contributions
Advantages of SEPs
- Very good for people who own their own business and have no W-2 employees
- Very low cost to set up and maintain (compared to a 401K plan)
- High contribution limit ($44,000 for 2006; $45,000 for 2007)
- Tax deduction on yearly contributions
- Tax deferred growth on earnings
Disadvantages of SEPs
- Not good for people with employees (high matching requirements)
- Money is in an IRA, so it has limited access before age 59-1/2 without incurring an IRS penalty
Before making any decisions, you should consult both an accountant and investment professional to determine what may be suitable for your specific situation.
Check out the IRS FAQ about SEPs.
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