When I see the word “SEP”, my mind goes to a SEPtic system. Immediately, I get the unpleasant thought of what’s inside. Not a pleasant thought. Thankfully, a SEP IRA is the exact opposite, and it provides business owners with a tax-advantaged way to save for retirement. Now that’s the opposite of gross. There are two audiences to which this post is aimed to serve. First, sole business owners with no employees. Second, small business owners with relatively few employees. Before we differentiate, let’s go over some introductory details on the SEP IRA. So what is it anyways?
A SEP IRA (which stands for Simplified Employee Pension Individual Retirement Account) is the easiest way to save for retirement. It’s essentially an IRA that’s affiliated with your business. A SEP IRA allows for employer contributions only. You can easily adopt them by completing a Form 5305-SEP.
How much can you contribute to a SEP IRA?
When people see IRAs, they think “I can only contribute $6,000 / year (2022) + $1,000 catch up contribution if I’m over 50”. However, SEP IRAs have different contribution maximums. For any employee, a business can contribute the lesser of 25% of compensation (up to $305,000) or $61,000 (2022) to the employee’s SEP IRA. There is no requirement to make a contribution. All contributions are 100% immediately vested.
Why would I want to open a SEP IRA?
It depends based on your business needs. For solo business owners (no employees), it’s very easy to set up. It lets you contribute much more than $6,000 ($7,000 if age 50+) into a Traditional IRA. You can contribute up to 18.59% of your net Schedule C income. So if you earn $200,000, you can put up to $37,180 into the SEP IRA. You are probably asking where the 18.59% comes from? The IRS requires that business owners have an adjustment down from the 25% for non-employee owners. It’s not worth getting into more weeds than this right now. If you have questions, please reach out.
You don’t pay income taxes on the deferment into SEP IRAs. It’s a great way to avoid some taxes and save for retirement. When you combine the ease of set up, the opportunity for substantial retirement savings, and the tax savings, it’s a great place to start for small business owners that are just starting out or growing rapidly.
For business owners with employees, SEP IRAs can offer an easy-to-implement retirement savings plan for employees. However, it’s not the best plan for all businesses. There is no requirement to contribute to the plan in any given year, but when contributions do occur, the percentage contributions for owners and employees must be equal. While this can be generous for employees, it gets expensive fast.
Imagine you have 10 employees. You want to contribute the maximum percentage to your own SEP IRA, and this means you must contribute that same percentage to every other employee’s SEP IRA. There are exceptions where employees can be excluded from contributions.
o Employees less than 21 years old
o Employees employed less than 3 years (out of the past 5 years)
o Employees whose salary is less than $650 / year (2022)
Let’s say you run an ice cream shop that primarily employs high school students during the summer, or you run a factory that has a high worker turnover each month. While we believe employees should be absolutely compensated fairly, it can be a hassle to keep up-to-date with employer contributions for workers that are not available for the long run. A SEP IRA would make your processing easier and allow you to easily contribute fairly high amounts to your own account without needing to contribute to your employee’s account. A SEP IRA would be a good fit for these types of business owner.
Now let’s assume that you have a quilting business that employs several office workers part-time, but those office workers will most likely work for 10+ years since it’s their retirement job. A SEP IRA could get quite expensive from a contribution perspective. If you wanted to contribute 15% of your salary to the business’s SEP IRA on your behalf, you would also need to contribute 15% to all these part-time employees’ salaries to their respective SEP IRAs. A SEP IRA would not be the best plan here.
Is there a Roth SEP IRA?
No. But you can do a Roth conversion from a SEP IRA to your personal Roth IRA each year. However, there is an alternative to a SEP IRA à Roth IRA conversion: The Roth Solo 401k. Soon we will write a whole blog post about a Roth Solo 401k and it’s accompanying Mega Backdoor Roth strategy. The bottom line is that if you own a solo business, and you are solely trying to maximize contributions into your personal retirement plan up to the legal limit, a Solo Roth 401k and the Mega Backdoor Roth will beat the Roth IRA conversion if you are more than 10 years from retirement (depending on your investment return assumptions).
We are passionate about serving small business owners. We specialize in tax planning, tax saving strategies, individual business retirement plan asset management, cash flow management, insurance analysis, business structing and exit strategies. We are also thrilled to integrate with your CPA. If you’d like to set up a free financial consultation about your small business, give us a call at 571-969-1459 or email IFP at ryan@ifpinvest.com.
