The Simplified Employee Pension Individual Retirement Account (SEP IRA) is a great option for the self employed and small business owners who want to get tax relief for the profit that the business (or individual) generates. Unlike 401k plans that come with administrative costs, SEP IRA is easy to setup and maintain. In addition, SEP IRA allows contributions of up to $46,000 in 2008.
SEP IRA’s Contribution Limits
In 2008, you can contribute up to $46,000 or up to 25% of your net profits, whichever is lower. Unlike a 401k plan though, there are no “catch-up” contribution no matter what your age is. In addition, withdraws are mandatory once you reach the age of 70 and a half.
SEP IRA’s Rules
This type of IRA is open for sole proprietors, partnerships, LLC and corporations (both S and C corps). For companies that have employees, the employer must contribute for each employee equal percentages of what the business owner contributes in his/her own plan. For example, if a business owner contributes 15% of her net profits to a SEP IRA plan, she needs to contribute at least 15% of all employees wages into the plan. (Note that an employee in this case qualifies as long as she made $500 for that tax year, at least 21 years old and worked at the company for three out of the last five years.)
Like a 401k, the contributions lowers the participants aggregate gross income (AGI) and thus lowers its taxes. However, withdraws are then taxed at the ordinary income rate.
A Note About the 25%
We’ve said that the contribution limit is $46,000 or 25% of your net profit (or wages if you are an employee). However, calculating your net profit is not that simple. When calculating your net profit, you need to take into account self employment taxes as well. For example, a business owner who makes a profit of $40,000 will not be able to contribute $10,000 to a SEP IRA plan. That’s because self employee taxes “eat away” at the net profit, so it’s a little less than 25%.
Sole propetiors have an even more complicated structure. When an employee makes $40,000 and its employer contribute $10,000 to its plan, the effective compensation is actually $50,000. In the case of sole properitors where the employer and the employee are the same person, the same rules to apply. Therefore, the contribution rate is 20% instead of 25% (closer to 18% when taken the self employment taxes into account).
Where are SEP IRAs Available
Actually, almost every institution that offer IRAs offer SEP IRAs. For those interested, just inquire at your favorite stock broker.
What the SEP IRA Mean for Us
The contribution limit is actually quite complicated as you can see but it is a great option for people who have limited employees or are self employed. Each type of IRA may offer different advantages but the tax advantages of contributing to one outweighs not having one by far. Therefore, it is highly recommended to have one set up immediately if you don’t haven’t yet.