Pros and Cons of a SEP IRA
By CHM on Mar 12, 2008 in Featured, Financial Planning, Retirement, and Now!
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Last week I wrote a post on different ways you can reduce your reported taxable income. Besides offering some tax advice to one of my blogging contemporaries - Blogger X , I listed a few retirement plans (for those with self-employment income) that allow you to sock away large sums of pre-tax money each year.
I’d like to take a closer look at 3 of the plans I mentioned in that post. For the sake of keeping it simple, I’m going to breakdown each plan into an individual blog post. Let’s begin with the SEP IRA, the plan of choice for last week’s subject - Blogger X.
SEP (Simplified Employee Pension) Plan Suitability
A SEP IRA is the way to go if you’re a small employer (typically less than 10 employees and many times just one employee, YOU!) looking for a simple retirement plan that’s easy to install and administer. Most financial institutions will have the plan documents on file and it’s as easy as opening up any investment or bank account.
The nice thing about a SEP IRA is you can open (or adopt) it at any point up until the due date of the employer’s income tax return, including filing extensions.
In last week’s post I talked about how Blogger X opened up a SEP IRA and was able to reduce his taxable income by making a 2007 contribution. The important thing here is… he was able to open the SEP IRA even though it’s 2008, and still make a contribution for 2007. With other qualified plans you must establish the plan within the year the deduction is going to be claimed. Here’s a list of some of the other pros and cons of having a SEP IRA:
Pros of a SEP IRA
- benefits are portable (100% vested)
- there are no employer filing requirements
- Easiest retirement plan for a small business to put into practice
- For 2008, if you are unincorporated, you can contribute the lesser of 20% of net earnings from self-employment or $46,000
- Contributions do not have to be made every year and are made by the employer only!
- If an employer has high turnover, employees won’t be eligible to receive employer SEP contributions.
Cons of a SEP IRA
- Part time employees who have worked 3 out of the preceding 5 years, earning $500 or more annually, must be covered by the plan
- which means if you contribute to the plan on your own behalf, you must do the same for any qualifying employee.
- if you have employees that will qualify for the plan and you don’t want to make contributions on their behalf, then a SEP IRA is not right for you.
- For 2008, A SEP allows you to contribute the lesser of 20% of net earnings or $46,000, while a Solo 401(k) allows you to contribute the lesser of 100% of your salary or $46,000. For example, if you net $30,000 in 2008, with a SEP you can only contribute $6,000, with a Solo 401(k) you could contribute the entire amount.
In conclusion
For most self-employed individuals, the simplicity and effectiveness of a SEP IRA make it a great way to sock money away for retirement and reduce your current taxable footprint, especially if you’re looking for last minute ways to reduce taxable income.
If you’re a high earner and have the ability to put away a significant portion of what you make, then a Solo 401(k) may be a better option. I’ll look at the Solo 401(k) sometime over the next couple days…
Tags: SEP IRA
My Dollar Plan | Mar 12, 2008 | Reply
Thanks for getting this article together. I have a reader who was anxiously awaiting the explanation of all the small business retirement account options!
CHM | Mar 13, 2008 | Reply
Thanks Mad… may have a few touch ups and edits tomorrow.
Thanks for the stumble and let me know if you have any questions:)
Jeff@My Super-Charged Life | Mar 13, 2008 | Reply
We had a SEP when I was a small business owner. It was a good deal. We did it for all the reasons that you outline above. It worked great for us. Nice article!
CHM | Mar 13, 2008 | Reply
Thanks Jeff. You can start planning to convert that SEP to a Roth IRA in 2010, if you want;)
Lazy Man and Money | Mar 17, 2008 | Reply
I have been looking into this as well as a way to reduce my tax bill for 2007. According to my tax expert it only reduces my normal income, not my schedule C income. This means that while it is a tax savings, my taxes of $5500 is reduced by about $500. This is simply deferred taxes, not exactly a huge savings for me at this point.
I wonder what will happen if all my income is Schedule C and I have no normal income. Something tells me it should come from Schedule C.
CHM | Mar 18, 2008 | Reply
@LazyMan - Yes, the SEP IRA deduction is taken off of your total taxable income (in order to arrive at your AGI) but the way you arrive at the deductible number (on your 1040) is by figuring out what your net earnings from self employment were, and taking the lesser of 20% or 46,000 for 2008.
Using my example, if Blogger X had net self employ income of $30,000 on his schedule C, he would have been able to deduct $6,000 of that from his total taxable income.
Mark | Jul 18, 2008 | Reply
Can you borrow against a SEP-IRA?
CHM | Jul 18, 2008 | Reply
No you can not borrow against it.
Anonymous | Sep 3, 2008 | Reply
!. How soon is the employer required to settle the distribution after the employee retires?
2. Can an employer change the time it takes to become 100% vested anytime they desire? What are the vestment rules?
3. Is the income tax the same percentage if you take the distribution in one lump sum as if you take it in small increments?
Wondering | Dec 19, 2008 | Reply
Just discovered your article on the internet; is it possible to fund both a Sep IRA and Roth IRA in the same year; assuming the SEP IRA contribution brings my income down to the limit?
Ed Leventhal | Apr 10, 2009 | Reply
I am 75 and self employed. I’m withdrawing from an IRA. Can I contribute to a SEP, based on my Schedule C?