Understanding SEP IRA Tax Rules

Estimated reading time: 3 minutes(Last Updated On: April 13, 2021)

retirement accountsMost working adults are at least somewhat familiar with the two most popular types of personal retirement accounts – the IRA and the 401(k). The 401(k) plan is by far the most common type of retirement program that we see at work. Unfortunately, these types of retirement plans are generally somewhat costly to administer, and the administrators of those plans really only promote them to mid-size and larger businesses.

Furthermore, many of the plans are limited to only certain types of mutual funds, which significantly reduces the ability of retirement savers to select exactly the types of investments they want to hold. For small businesses (even sole proprietors), setting up a 401(k) is likely to be a less than ideal way to provide additional benefits to themselves and their employees.

Fortunately, there is another option – the SEP IRA. SEP IRA stands for “Simplified Employee Pension IRA,” and it’s an account type that combines the best of both worlds; the higher contribution limits of employer-sponsored plans with the tax benefits and low costs and investment flexibility of IRAs. Here are some of the key SEP IRA tax law basics.

The SEP IRA Must Not Be Preferential. All employees must receive the same benefits under an SEP IRA. This means that a small business owner cannot open up this type of retirement plan only for themselves. If they choose to open the plan they must set up an account and make the same types of contributions for all eligible employees.

Additional Employee Requirements. In addition, employees other than the business owner must also meet several additional requirements. The employee must be at least 21 years old, must have worked for the employer for at least three of the past five years, and must have received at least $500 in compensation during the year.

Tax Treatment of Contributions and Withdrawals. Contributions to a SEP IRA are similar to those of a traditional IRA when it comes to taxability. That is, contributions are generally tax-deductible, and withdrawals are generally taxed at the account holder’s then current marginal tax rate.

SEP IRA Contribution Limits. Calculating the annual contribution limits for a SEP IRA is more complicated than doing so for a Traditional or Roth IRA. The SEP-IRA is considered an employer-sponsored plan. Contributions must be made by the employer and can vary each year between 0% and 25% of compensation (maximum $57,000 for 2020 and $58,000 for 2021). Each eligible employee must receive the same percentage.

For self-employed individuals who set up a SEP IRA, determining the contribution limit is more complicated. The best way to make the computation is to use IRS publication 560 (section 5), but in general the contribution limit will be approximately 18.6% of the businesses in net profit. Further complicating matters is the fact that the contribution limit is computed not from the businesses net profit but from an adjusted figure that takes into account the applicable self-employment tax.

There are a few other factors that could further effect the computation. For more information please contact Quest Trust Company or any other experienced IRA custodian.


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