SEP IRA

In short

A friend of mine ran a small landscaping business for years and never saved a dime for retirement, because he thought you needed a big company and a payroll department to do it. If you work for yourself, or you own a small shop, this is for you. A SEP IRA is a retirement account that lets a business owner put money away from business income. The employer alone puts money in, and the limit is set each year by the IRS, which is currently the current figure, which the official source publishes each year. Every eligible worker must get the same percent of pay, and that includes the owner. You can open one in an afternoon at a bank, a brokerage, or a mutual fund company. Check the IRS page on SEPs before you sign anything.

The whole of it

What it is

I once watched a neighbor of mine try to explain a retirement plan to his wife, and by the end they were both staring at the ceiling. So let me keep it plain. SEP stands for Simplified Employee Pension. It is an individual retirement account, or IRA, that an employer sets up for each eligible worker. If you are the only worker, you set it up for yourself.

You have probably heard of the regular IRA, the one you open on your own. This one is different in who pays. Only the employer puts money in. Workers do not add their own paychecks to it. For a self employed person, that means you wear both hats. You are the boss who gives, and you are the worker who gets.

The account belongs to the worker. That part matters. Money the employer puts in is the worker's money right away, with no waiting period. The employer cannot take it back later.

The Internal Revenue Service, or IRS, describes the plan on its page titled Simplified Employee Pension plan (SEP). The rules for it also live in a document called Publication 560, Retirement Plans for Small Business. Both are free and worth a read.

How it works

If you are thinking about opening one, here is the road it follows. First, the employer signs a written plan. The IRS offers a short form for this, called Form 5305-SEP. Many banks and brokerages have their own paperwork that does the same job. The employer then opens an IRA for each eligible worker.

Next comes the money. The employer decides each year how much to give, or whether to give at all. There is no promise to pay in a slow year. That freedom is a big reason small owners like the plan. A lean year can pass with no deposit and no penalty.

The rule that keeps it fair is this. The employer must give every eligible worker the same percent of pay. If the boss puts in 10 percent for herself, she must put in 10 percent for the others too. She cannot play favorites.

A worker is eligible under the IRS rules if the worker is at least age 21, has worked for the business in at least three of the last five years, and earned at least a set amount that year. That pay floor changes, so the plan paper and the IRS page will show the current figure, which is the current figure, which the official source publishes each year.

The money goes in before tax, which means the employer can deduct it as a business cost. The savings then grow without yearly tax. The owner of the account pays income tax when money comes out in retirement. Taking money out before age 59 and a half usually brings an added 10 percent tax, with some exceptions, as the IRS explains.

The numbers, and where to find yours

The limit is the part people mix up, so go slowly here. Two caps apply at once. The employer can give up to 25 percent of a worker's pay, or the yearly dollar cap, whichever is smaller. The dollar cap for this year is the current figure, which the official source publishes each year. The pay that counts is also capped, and that figure is the current figure, which the official source publishes each year.

For a self employed person, the 25 percent works out smaller than it sounds. The IRS explains that the owner's share is figured on net earnings after taking out half of self employment tax and the plan contribution itself. Publication 560 has a worksheet for this, and it is the right place to check your own number.

You can find your net earnings on Schedule C of your tax return. That is the form a sole owner files to report business profit or loss. The final line there is your starting point.

The deadline is kind. An employer can make the deposit up to the due date of the business tax return, including extensions, and still count it for the year before. So a deposit made in the spring can count toward the prior year. Look at the IRS page for the exact rule.

A worked example

Let me tell you about Marguerite, who runs a small bakery by herself. She is the only worker. Last year her business earned a net profit of $80,000 on Schedule C.

She cannot just take 25 percent of $80,000. The IRS wants her to adjust first. Half of her self employment tax comes off. Say that half is $5,650. That leaves $80,000 minus $5,650, which is $74,350.

Now the contribution has to come out of its own base. Publication 560 has a rate table and worksheet that turn the plan rate into the figure an owner uses. In this story, say the worksheet gives her 0.20. Then $74,350 times 0.20 is $14,870. That is the most Marguerite could put in, as long as it stays under the yearly dollar cap of the current figure, which the official source publishes each year.

Say she decides to give $10,000 this year, not the full amount. Ten thousand dollars is under both the 20 percent figure of $14,870 and the dollar cap. She opens a SEP IRA at a bank, signs the form, and deposits $10,000 before her tax filing date. Her business deducts the $10,000. If she pays tax at a 22 percent rate on the last dollars she earns, that deduction cuts her federal income tax by $2,200, because $10,000 times 0.22 is $2,200.

Now suppose she hires a helper, Daniel, who earns $30,000 and is eligible. If Marguerite gives herself 10 percent of her pay, she must give Daniel the same percent. Ten percent of $30,000 is $3,000. That is a cost she has to plan for. The plan is simple for one person and less cheap for a crew.

Where it goes wrong

I have seen good people trip on the same few stones, so let me point them out kindly.

The first is the equal percent rule. A boss with staff who forgets it can end up with a plan that breaks IRS rules. Fixing that costs time and money. Hire help, and the plan stops being a solo affair.

The second is the limit. Putting in more than the allowed amount creates an excess contribution. The IRS may charge an extra tax on that excess until it is fixed. Count twice, deposit once.

Third, many folks think a SEP IRA lets them add their own paycheck money. It does not. Only the employer gives. A worker who wants to save from a paycheck has to use a different account.

Fourth, the money is not locked in the way a pension might be. The worker owns it from day one, and a worker who leaves keeps it. That is good for the worker and a thing to weigh for an owner with staff.

Last, taking money out early brings that added tax I mentioned, and the IRS sets required withdrawals starting at a certain age. Look up that age at the IRS page, as it has changed by law more than once.

Questions to answer before you leave this page

Are you the only worker in your business, or do you have people who would also be eligible, and can you afford to give them the same percent of pay that you give yourself? Do you know your net earnings from Schedule C, and have you worked through the Publication 560 worksheet to find your own limit instead of guessing? Have you checked the current yearly cap and pay floor on the IRS page so your numbers are fresh? Will you want the freedom to skip a year when money is tight, and does a plan with no required deposit suit how your income rises and falls? Do you understand that the account is the worker's from the first dollar, and that money taken out early may carry extra tax? And have you asked a bank, a brokerage, or a tax preparer you trust to walk you through the form before you sign?