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SEP IRA

Simplified Employee Pension Individual Retirement Arrangement

What is an SEP IRA?

A SEP IRA (Simplified Employee Pension Individual Retirement Arrangement) is a slight variation of traditional IRAs that are used by businesses for themselves and their employees. Most commonly, SEP retirement plans are used by individuals that are self-employed; employees working for the individual must all receive the same benefits in order to be eligible for the SEP plan. Any funds invested in an SEP IRA can be invested in the same ways that a traditional IRA invests.

 

SEP IRA

 

There are different restrictions that may be placed on a SEP, depending entirely on the employer’s specifications. However, under the harshest of restrictions, an individual may use a SEP if:

  • They’ve worked for the same employer at least three out of the past five years.
  • They are at least 21 years old.
  • They’ve made a minimum of $600 for the relevant tax years.

 

Deadlines for SEPs (when contributions must be made) are the same as the filing deadlines for the employer’s tax returns. They include any extensions that are requested and granted.

Ordinary income tax rates are used on SEPs, provided qualified withdrawals are made after the age of retirement. They are the same type of rates applied to traditional IRAs. All contributions are tax-deductible, which means the contributor’s income tax liability is lowered for the year.

 

Summary: 

  • An SEP IRA, or Simplified Employee Pension Individual Retirement Arrangement, is designed for self-employed individuals and their employees.
  • Individuals employed by self-employed individuals can have no more than 25% contributions made to their SEP plans.
  • Contribution limits for self-employed individuals are slightly more complex and are affected by several factors.

 

Contribution Limits for the Employed

Contributions for a SEP IRA are viewed as part of a profit-sharing plan; the employer can tribute as much as 25% of the employee’s wages. For example, if the employee earns $80,000 for the year, the employer can contribute up to $20,000.

Total contributions to a SEP for the year should not be in excess of 25% (or closer to 20%, in the case of the self-employed individual with no employer). As of 2011, earnings for an individual have been capped at $245,000, which means that the employer can’t contribute more than $61,250.

 

Specifications for SEP IRAs for the Self-Employed

Restrictions on SEPs for the self-employed are more complex. Outside of any other limits specified by a state, a self-employed individual can contribute approximately 18.6% of his or her net profit for the year. Part of what could complicate said amount is the Federal Insurance Contributions Act (FICA) tax.

 

FICA Tax

With the FICA Tax, contribution limits are calculated using an individual’s net profit with adjustments for self-employment deductions. (The deductions are determined on Form 1040; calculations are done in Section A, line 6 or Section B, line 13.)

Ultimately, what it means is that adjusted net profit is equal to 92.9% of net profit. It’s almost the full amount of net earnings, but slightly less to account for the self-employment tax.

So, the contributing limit for self-employed individuals is approximately 92.9% of 20%. Or, as stated above, 18.6% of the net profit.

 

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • 401(k) Contribution Limits
  • 457 Plan
  • FUTA Tax
  • Social Security

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes and training program!