SEP IRA Rules and Contributions: What you need to know

What is a SEP IRA?

A SEP IRA is short for a Simplified Employee Pension Individual Retirement Account. It is basically an IRA account which employers have the ability to contribute to. Employers benefit from having an SEP IRA because it is easier to set up than a 401(k) and also costs less to administer.

Who is eligible?

All employees are eligible are long as the meet these three requirements:

  1. At least 21 years old
  2. They have worked for the employer at least three of the past five years
  3. They have received compensation of $500 or more for the tax year

As a result, any employee who meets these three requirements must participate in an SEP, even if they are only part-time, seasonal, were laid off, fired, etc., during the year.

Why would you want to choose a SEP IRA?

SEP IRAs are must easier to set up than a 401(k). It is basically the same as setting up a regular old investment account. Start up and maintenance costs are also very low when compared to 401(k) plans. Contributions are discretionary, so the employer can decide if they want to contribute to the retirement plan that year. SEP contributions and Traditional IRA contributions are completely separate. That means the employer and employee can contribute to the same IRA account, and the limits applied to the two accounts do not affect one another. A SEP is a very attractive option to a small business owner that wants to provide a retirement account to employees at a low cost.

What are the contribution limits to a SEP IRA?

Employers are allowed to contribute the lesser of 25% of an employee’s compensation for the year or up to $52,000 for the 2014 taxable year. The limit that employers can contribute for themselves is a little more complicated, but it is basically 18.6% of net profit.

What other rules are applicable to a SEP IRA?

The employer must provide the same amount to every employee. For example, if the owner contributes 10% to Sally’s retirement account, they must contribute 10% to every single eligible employee’s retirement account. The last day you can make contributions to a SEP is either April 15th or the extension due date. A SEP IRA is very similar to a Traditional IRA in that:

  1. You can begin to make withdrawals at 59 ½ years old
  2. You must take required minimum distributions at 70 ½ years old.
  3. Funds are invested in the same way as a traditional IRA

Final Word

SEP IRAs are great options for small business owners who are looking to create an employer contributed retirement account for either themselves or their employees.

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Why you should always choose a Roth IRA

In my previous post I discussed the difference between a Traditional IRA and a Roth IRA. In this post I’m going to talk about why you should choose a Roth IRA over a Traditional IRA.

What a Roth IRA?

A Roth IRA is a retirement account which allows you to put away $5,500 (after taxes) a year. While these contributions are not tax deductible, a Roth IRA will pay off when you actually do withdraw your money. You see, with a Roth IRA you are allowed to take out your money without paying any taxes! You will get away with paying a 0% tax rate in retirement. What’s better than that?

I want to withdraw money from my Roth IRA, will I face a penalty?

You are allowed to withdraw your contributions from a Roth IRA at any point and time without facing a penalty. Here it is important to differentiate between contributions and earnings. Say you put in $1,000 and earn $50 in interest in your Roth account. You are allowed to withdraw your original $1,000 without facing any penalty! Why is this so wonderful? With a Traditional IRA you are required to pay both taxes AND a 10% penalty if you withdraw ANY money from your account.

In addition, you may contribute to a Roth IRA if you also participate in a 401(k) plan from your employer. While you may also be allowed to contribute to a Traditional IRA, you lose the benefit of deducting a certain percentage of your contribution, depending on your income rate. See the chart for deductions in my previous blog post. With a Roth IRA, you do not have to give up the benefit of tax free withdraws just because you have a 401(k). In summary, if you have a 401(k), open up a Roth IRA to maximize the tax benefits.

Finally, a Roth IRA does not require distributions based on age. You see, when you have a Traditional IRA, you are required to make withdrawals at the age of 70 ½ years old. With a Roth IRA you do not have to make withdrawals. If you are old and have a ton of money stashed away, you are not required to take money out of your Roth. Why does this matter? You will be allowed to let your wealth continue to build TAX FREE after the age of 70 ½, which means your can leave more money to your beneficiaries.

What are you waiting for? Open a Roth IRA today!

Traditional vs. Roth IRA, Which one should I choose?

What is a Traditional IRA?

An IRA stands for Individual Retirement Account. IRAs are held at banks and brokerages and allow you to invest in almost anything you can imagine. The benefit of having a Traditional IRA is that you can deduct your contributions on your tax return.

What is a Roth IRA?

A Roth IRA is very similar to a Traditional IRA. There is one exception: the money you contribute to a Roth IRA is taxed today (you cannot take a deduction on your tax return for contributions), but it is not taxed when you withdraw any money in the future. Therefore, all money you take out of an IRA, included gains on your investments, are not taxed in the future.

How much can I contribute to my IRA?

When you have an IRA, either Traditional or Roth, the most you can contribute is the lower of $5,500 or your taxable compensation for the year. If your taxable compensation is below $5,500, then you will be limited to the amount of your taxable income for the year. If you are over the age of 50, you are allowed to contribute $6,500 to your IRA.

How much can I deduct on my taxes for my IRA?

The amount you can deduct on your taxes depends on one condition: Do you or your spouse (if married filing jointly or separately) have a retirement plan at work? If the answer is no, they you are allowed to deduct the full amount of your contribution to your IRA. If the answer is yes then it can be a bit tricky.

I have a retirement plan at work, how much of my IRA contribution can I deduct?

The following chart is provided by the IRS to help determine how much of your IRA contribution you can deduct when you are provided with a retirement plan at work:

If Your Filing Status Is…

And Your Modified AGI Is…

Then You Can Take…

single or
head of household

$60,000 or less

a full deduction up to the amount of your contribution limit.

more than $60,000 but less than $70,000

a partial deduction.

$70,000 or more

no deduction.

married filing jointly orqualifying widow(er)

$96,000 or less

a full deduction up to the amount of your contribution limit.

 more than $96,000 but less than $116,000

  a partial deduction.

 $116,000 or more

 no deduction.

married filing separately

 less than $10,000

  a partial deduction .

 $10,000 or more

 no deduction.

If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “single” filing status.
married filing jointly with a spouse who is covered by a plan at work

$181,000 or less

a full deduction up to the amount of your contribution limit.

more than $181,000 but less than $191,000

a partial deduction.

$191,000 or more

no deduction.

married filing separately with a spouse who is covered by a plan at work

 less than $10,000

 a partial deduction.

 $10,000 or more

 no deduction.

By utilizing this chart, take your filing status and adjusted gross income, and you can see if you are allowed to deduct the full amount, a partial amount, or no amount.

When can I withdraw money from my IRA?

The IRS allows you to withdraw from you IRA (Traditional and Roth) without any penalties after the age of 59 1/2. If you do withdraw from your IRA before this age you will be hit with a 10% penalty on top of the taxes you owe to the IRS. There are certain exceptions that will allow you to withdraw money penalty free before the age of 59 ½, which I will discuss below.

How can I withdraw money from my IRA without facing a penalty?

  1. You are over the age of 59 ½ you can withdraw money from your IRA penalty free. ‘
  2. You use withdrawals to pay higher education costs for your spouse, your children, or grandchildren.
  3. You can take up to $10,000 (or $20,000 if you are a couple) to buy, build or rebuild your first home.
  4. You use money from your IRA to pay for medical expenses in excess of 10% of your AGI which are not reimbursed during the taxable year.
  5. You become disable and can no longer be gainfully employed.
  6. You die and leave it to an heir.
  7. Roth IRA – You can withdraw your contributions but not your earnings (interest and dividends accumulated) from your Roth IRA at any point in time.

How long can I contribute to my IRA?

If you have a Traditional IRA, you are allowed to make contributions until the age of 70 ½ years old. If you have a Roth IRA, you are allowed to make contributions as long as you are alive.

Should I choose a Traditional IRA or a Roth IRA?

When deciding between a Traditional IRA and a Roth IRA, it could be tricky. With a Traditional IRA you can deduct your contributions in the current year that you make them. This is appealing if you want to lower to tax burden in the current year. You would also want to choose a Traditional IRA if you believe you will be in a lower tax bracket when you are older. That way you limit your tax payments to the lower future tax rate. In addition, you can contribute to a Traditional IRA at any time without income limitations. This differs from a Roth IRA which does not allow you to make contributions if you make over a certain income level.

With a Roth IRA, you cannot deduct your contributions in the current year that you make them. However, you will not be taxed on the money you take out of a Roth IRA in the future. This is appealing if you think you will be in the same or higher tax bracket when you are older. In addition, you can take out your principal contributions at any time without facing a penalty.

When it comes to choosing retirement accounts, take your time. Consult with your accountant or tax professional and make sure you pick the retirement account that best suits your needs.