"Simple" Retirement Savings: Demystifying the SEP-IRA
NEW YORK ( MainStreet) The Simplified Employee Pension Individual Retirement Arrangement ( SEP-IRA) is an easy way for small business owners or self-employed people to set up a qualified retirement plan. It requires minimal administrative work and can be opened with custodians like Vanguard, Charles Schwab, Fidelity or TD Ameritrade.
Established by the Revenue Act of 1978, SEP-IRAs went into effect January 1979.
This arrangement permits employers to contribute to traditional IRAs started for their employees. Any business of any size, even self-employed, can create one.
The purpose was to provide deferred retirement benefits for business owners and their employees. If a self-employed person has employees, all employees must receive the same benefits under a SEP plan. All SEP contributions are made by the employer. Their employees can contribute to personal IRA accounts.
"Many people think SEP-IRA means 'Self-Employed Pension Individual Retirement Arrangement' but it really means 'Simplified Employee Pension Individual Retirement Arrangement,'" explained Rob Morrow, a tax law professor at Chapman University School of Law.
"As the name implies, it is much like an IRA and the whole idea is for it to be exceedingly simple," he said. "While any employer can establish a SEP-IRA, a large employer would not because it would be too inefficient."
So why exactly do people establish SEP-IRAs? For one reason, a self-employed individual cannot defer profits that is, he can't exclude profits from income. But the person could use this vehicle to take a portion of the profit and defer its recognition as income by taking a deduction for the contributions made to the plan.
"Say you go to work at Starbucks and you participate in their 401(k) plan," Morrow said. "Starbucks takes money out of your paycheck and deposits it in this plan. Since a self-employed person cannot defer their profits, the SEP-IRA permits them to take a portion of their income and defer it like an IRA or 401(k) plan."
There are some difference, he pointed out. Contribution limits are larger for SEP-IRAs and 401(k)s (also called Cash or Deferred Arrangement plans or CODAs) than for IRAs. The 2014 contribution limit for an IRA, for example, is $5,500 for most people, whereas the 2014 limit for a SEP-IRA can be as high as $52,000.
But generally speaking, all of these vehicles are Individual Retirement Arrangements.
One benefit of these deferred compensation plans is that your money is invested before taxation, thus leaving more of it to invest. The income the plan earns is also not taxed - so long as it stays in the plan. Therefore more remains to reinvest. The result is that more money available for the participant's retirement.
The only time qualified money is taxed is after one retires and it is withdrawn. Theoretically, this is a period when one's income is less. Conceptually, during a period of lower earnings, one's tax liability rate is also less.