Whether you run a business with employees, or are self-employed or do freelance work, you should set up tax-advantaged savings accounts for retirement. There are several types of retirement accounts you can use, which I’m going to review in a series of posts. They each have quirks about how contributions are made, the amount of money you can contribute each year, and income limits for employees making contributions. You should study all of the options to see which is best for your organization. The first option I’m going to cover is the SEP IRA.
With a SEP IRA, contributions are primarily made by the employer. Depending on how your organization’s SEP IRA is set up, employees may also be able to make contributions to their accounts. If an employee contribute, and also contributes to a traditional IRA outside of work, the SEP contributions may reduce the amount they can deduct on their tax returns for the traditional IRA contributions. They should consult with their tax preparer to see if this impacts them.
The most an employer can contribute is 25% of an employee’s income, or $56,000, whichever is less. $56,000 is the maximum for 2019, and goes up each year based on cost of living adjustments. Self-employed people using a SEP IRA can contribute the same amount, with some special rules to calculate the maximum deductible contribution. See IRS Publication 560 for details.
Be aware that you have to make the same contributions for all eligible employees. For example, if the owner of the company contributes 10% of his/her wages to the SEP IRA, then he/she must contribute 10% for everyone. Eligible employees are those who are at least 21, earn at least $600 of wages, and have been at the organization at least 3 of the last 5 years. This can get expensive if you have a lot of employees, in which case you may want to use a 401(k) or 403(b), which have lower requirements for how much employers contribute.
One advantage of a SEP IRA is that you’re not required to make contributions every year. You can increase contributions in years when the organization does well financially, and you can reduce or skip contributions when there’s a downturn. When you make contributions, you’re allowed to wait until the due date for filing your federal tax return, including extensions. The employer can take a tax deduction for all contributions they make.
The SEP IRA is not a Roth savings vehicle, so distributions taken in retirement will be taxable income. You could rollover funds to a Roth IRA, or a Roth 401(K), or 403(b) at another employer, which would trigger a tax bill when you do the rollover but distributions would be tax-free. If you’re the employer, consider whether you’d like to give employees the option to use a Roth savings vehicle through your organization. At retirement age, a significant portion of the account balance will be growth, rather than the contributions made along the way, so using Roth accounts can provide a lot of tax savings.
Other types of retirement plans to consider: