Personal Finance

Money Matters: SEP IRAs are a great retirement plan for the self-employed

Q. I lost my job in 2014 and started working as a consultant in 2015 for the same company. After all of my expenses, I made more than I earned as an employee. I’m working on my taxes and while I’m grateful for the high income, my taxes owed are crazy high! A friend mentioned something called a SEP, would this help with my 2015 income. If so, how do I get one?

A. Congratulations on your success. Simplified Employee Pension IRAs (SEP IRAs) are great retirement plans for the self-employed or small business owners. You have until your filing deadline, including extensions to set one up and get it funded. You may be able to get a plan established and make a contribution for 2015 by the due date of your business tax return but since you can file for an extension, you have plenty of time. Almost all financial institutions, brokerage firms and mutual fund families have prototype SEP plan documents. The IRS also has a form you can use (5305-SEP), this and information is provided in IRS Publication 560.

A SEP IRA is available to any size business and is very easy to set up and operate. There are no IRS filing requirements as with most other retirement plans so administrative costs are low. You can also keep investment costs low by using a no-load fund family or a discount brokerage such as Charles Schwab, TD Ameritrade or Scottrade.

Only the employer may contribute to the SEP IRA and contributions must be the same percentage of salary for each employee. For 2015, contributions cannot exceed the lesser of 25 percent of the employee’s compensation or $53,000. The percentage limitations are slightly lower for a self-employed individual. The self-employed can only contribute 20 percent of their net profit adjusted for the self-employment tax deduction which works out to around 18.57 percent.

Even though you must contribute for all employees you can have eligibility requirements. When you establish the eligibility rules be careful you don’t disqualify yourself from the plan. The rules can be more lenient than the following but they cannot be more strict: employee must be at least 21 years old, worked for the employer three of the past five years and earned at least $600 in the tax year for which the contribution is being made. The employee is always 100 percent vested (the owner) of all money contributed on their behalf.

In the years you contribute all eligible employees receive a contribution. The nice thing with a SEP plan is that you can adjust your contributions percentages annually. In profitable years you may wish to make a large contribution and in lean years a smaller contribution or none at all.

In addition to the plan document, a SEP-IRA account will be established for each participant. Contributions which are tax deductible to the business owner are made into the SEP-IRA accounts. Any distributions are subject to the same rules as a traditional IRA. Distributions are taxed at ordinary income rates and a 10 percent early penalty applies to distributions made prior to age 591/2. Certain exceptions allow the IRS to waive the 10 percent penalty but in general this money should not be touched prior to age 59 ½. Required minimum distributions (RMD) are mandatory at age 70 ½ with the first RMD beginning before April 1 following the year you turn 70 ½.

You may also be able to make a contribution to a traditional or a Roth IRA, I’ll address that next week.