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A CREDO TAX PLANNING STRATEGY SOLUTION

SEP IRA: An Ideal Retirement Plan for Small Business Owners and Self-Employed Individuals

This detailed whitepaper serves as an expert resource on Simplified Employee Pension Individual Retirement Arrangements (SEP IRAs), offering key insights into retirement planning strategies. It breaks down the mechanics of SEP IRAs as a robust retirement planning tool, highlighting their tax advantages that are particularly beneficial for small-scale businesses and self-employed individuals. Designed for clarity and comprehensiveness, this guide is an indispensable tool for anyone aiming to maximize their retirement savings through tax-effective methods. Whether you’re a business owner or an independent professional, this guide is tailored to help you understand and leverage SEP IRAs for a more secure financial future.

In 2022, the contribution ceiling for Simplified Employee Pension (SEP) IRAs has seen an increase to $61,000, rising from the previous $58,000 limit in 2021. This retirement plan necessitates equitable contributions for all qualifying employees, with these contributions being tax-deductible. This is particularly advantageous for both sole proprietors and employers. The SEP IRA is noted for its streamlined approach, making it an attractive option for small business owners who are in search of tax-efficient savings solutions for themselves and their employees. When compared to more intricate plans like 401(k)s, SEP IRAs stand out with their simplicity and higher contribution thresholds, ideally fitting businesses with less than 10 employees. This characteristic bolsters the SEP IRA’s position as an optimal retirement saving strategy, marrying ease of administration with notable contribution limits.

WHAT IS A SEP IRA?

Simplified Employer Pension Plans or SEP IRAs are retirement plans that allow self-employed individuals and business owners to gain numerous benefits from it.  For businesses, aside from being 100% tax-deductible, the plan also allows them the following:

  • Be able to share up to the lower 25% of each employee’s compensation or $58,000 in 2021 and $61,000 in 2022.

  • Eligible to flexible contribution as the percentage of employee contribution can vary from year to year.

  • Able to consolidate with other retirement plans excluding a Roth IRA or accounts that also have after-tax contributions.

  • Defer taxes until you withdraw. The withdrawals made before age 59 ½ will yield a 10% penalty aside from the tax.  Withdrawals to pay medical bills or purchase a house are exempted.

SEP IRA BENEFITS FOR SMALL BUSINESSES

Potential Tax Benefits

Employers seeking to support their employees’ retirement planning, yet concerned about potential costs, can now benefit from an expanded tax credit. Under the new provisions, eligible employers can contribute up to $5,000 annually for the first three years of initiating a Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) plan. This tax credit equals 50% of the qualified start-up expenses, up to the specified limit, offering a substantial financial incentive for businesses to establish retirement plans. This update is particularly beneficial for small to medium-sized businesses aiming to enhance their employee benefits package while managing expenses effectively.

Minimal Administrative Costs

SEP IRAs present an ideal solution for small business owners, characterized by minimal paperwork and low initiation costs. This retirement plan option enables business owners to make contributions not just for themselves but also for their employees, with the added benefit of these contributions typically being tax-deductible for the business. This feature makes SEP IRAs a cost-effective and administratively simple choice for small businesses looking to enhance their retirement benefits offering.

Yearly Flexibility in Contributions

SEP IRAs offer small business owners unparalleled flexibility, allowing them to adjust their contributions based on the financial performance of their business. This means they can increase contributions during prosperous times and reduce them when finances are tighter. When it comes to employee eligibility, owners can either adhere to the standard IRS requirements or opt for their own, less restrictive criteria. This adaptability makes SEP IRAs an attractive option for small businesses seeking a retirement plan that aligns with their fluctuating financial landscape and accommodates their specific workforce needs.

Helping Employees Plan for the Long-Term

SEP IRAs stand out with their diverse investment options, providing employees with the flexibility to transfer or roll over funds between their SEP IRA and other retirement accounts. This capability is particularly advantageous for those looking to consolidate their retirement savings into a single, manageable account. Such versatility in managing retirement funds enhances the appeal of SEP IRAs, offering a practical solution for employees to streamline and optimize their long-term savings strategy.

Contribution Amount Flexibility

As of now, the contribution limit for a SEP IRA is set at $58,000, which will increase to $61,000 in 2022, or up to 25% of an employee’s eligible compensation, whichever is lower. For business owners, the contribution limit is 20% of their net self-employment earnings, as stipulated by SEP IRA regulations. It’s important to note that only employers can make deferral contributions on behalf of their employees in a SEP IRA. These contributions are generally tax-deductible for the business, providing a fiscal advantage. Additionally, depending on the financial climate of the business, employers can often contribute more to a SEP IRA than to a Traditional IRA, making it a potentially more beneficial option for retirement savings.

Limited Liability

The fiduciary responsibilities of employers are significantly reduced in a SEP IRA setup, as participants are empowered to select their own investments once they have established their SEP IRA accounts. This feature not only simplifies the employer’s role but also provides employees with the autonomy to tailor their investment choices to their individual retirement goals and risk tolerance, enhancing the overall appeal and effectiveness of SEP IRAs for both parties.

TAX PLANNING WITH SEP IRA

  • SEP-IRAs contributions are tax-deductible to the self-employed or to the business owner who makes the contributions. This is how SEP IRAs play the role in tax planning:

  • Any investment income earned inside the SEP-IRA is tax-deferred.

  • The contributions can be made after the end of the tax year.

  • Participants have control over how the contributions are invested.

  • The remaining fund can be rolled over to traditional IRAs.

    The plan can be utilized in addition to traditional IRAs and Roth IRAs.

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  • Any investment income earned inside the SEP-IRA is tax-deferred.
  • The contributions can be made after the end of the tax year.
  • Participants have control over how the contributions are invested.
  • The remaining fund can be rolled over to traditional IRAs.
  • The plan can be utilized in addition to traditional IRAs and Roth IRAs.
  • Excess contributions can be carried over and deducted in the following year.
  • SEP contributions increase deductions, thus lowering taxable income (which then results to lower tax calculation).
  • SEP contributions for self-employed persons are subtracted as an adjustment to income.
  • Income adjustments lower AGI (adjusted gross income) which is impacting to numerous AGI-sensitive deductions and tax calculations. SEP contributions helps to qualify for a particular tax break since it lowers the AGI.
Reduction of Federal Income Taxes Through SEP IRA
  • Funded using pre-tax dollars, a SEP IRA can reduce tax liabilities in explicit ways.
  • Self-employed individual contributing SEP IRA for himself: When a self-employed person contributes to his own SEP IRA, these contributions are deducted as an adjustment to income on Form 1040, line 10a, using Schedule 1. When an individual’s AGI is reduced through SEP contributions, the taxable income is reduced as well (and so is the federal income tax). The self-employment tax is not impacted by SEP contributions because that is computed prior to the calculation of SEP contributions. So a self-employed individual reduces income tax merely by contributing to his own SEP IRA.
  • A self-employed individual contributing to the SEP IRAs of his employees: When a small business owner contributes to his employees’ SEP IRAs, his business expenses are boosted which result to lower net profit, thereby reducing both the employment and income tax.
  • In addition to the mentioned tax benefits, SEP IRA contributions are exempt from FIC (Social Security and Medicare taxes). This means that the employer-employee does not pay FICA on the SEP contributions.
Investment Income Earned Inside the SEP-IRA is Tax-Deferred
  • SEP contributions can indirectly reduce other taxes that are computed based on AGI or taxable income (including the AMT or alternative minimum tax and the 3.8% net investment income tax).
  • Just like in any other retirement savings plans, the investment income produced on funds inside the SEP IRA is tax-deferred. Given this, the interest, dividends, and capital gains generated inside the SEP IRA are not included in an individual’s annual tax return. Tax is merely imposed when money is allocated from the SEP IRA. Investment income can be reinvested without needing to pay tax on earning first since it is tax deferred. These tax-deferred computing results to the accumulation of a larger account balance over time.
  • With this tax deferral capability, an individual can move income and its corresponding tax liability to a future time. Moving income to some point in the future can give the individual control on the level of income by deciding on the schedule and amount of distribution from the SEP IRA.
  • Such control on the income amount allows an accurate control of the tax. Preferably, individuals would like to deduct contributions when he is on a relatively high tax bracket and take distributions in a future time when he belongs to the lower tax bracket.
Benefit from the Setup and Funding Due Dates
  • SEP plans can be funded and adopted until the tax return’s due date (extensions are granted). What is notable about SEP is that funding it gives self-employed individuals to increase their deductions for last year by spending money on the current year. A self-employed individual who is filing a Schedule C can set up a SEP and contribute funds to a SEP-IRA as late as April 15th (no extension is allowed), or October 15 (with an extension), and have the contributions subtracted on their tax return for the previous calendar year.
  • Those who do not have a retirement plan yet, a SEP plan can be set up for the current year and make it effective on the last tax year. If SEP IRA is funded by the due date of the return, the contribution amount can be decided once all the tax impacts are sufficiently known.
  • Contributions can also be spread out over a longer period of time to take advantage of the funding due date as a way for businesses to budget their retirement savings.
    Funds can be contributed for a particular tax year starting on January 1 of that year and ending as late as October 15 of the next year (total of 21 months and 15 days).
  • Sample Scenario:
    Anna is a self-employed fashion designer who is filing a Schedule C and is completing her tax return in September. She requested an extension prior to April 15 (the due date of her return is October 15). To increase her deductions (she aims to lower her tax liability), she opened a SEP IRA. Given this scenario, Anna can deduct her contributions on her tax return for as long as the SEP plan is adopted and funds are contributed prior to or on October 15.
    Anna, in contrast, could fund a solo 401(k) or other retirement plans for small businesses if she has adopted the plan in a previous tax year. This makes SEP IRAs appealing because it can be adopted and funded after the close of the tax year.

SEP IRA DUE DATES

SEP IRA TAX IMPACT AT FEDERAL LEVEL

FAQS

What is a Simplified Employee Pension Individual Retirement Arrangement (SEP IRA)?

A SEP IRA is a type of retirement plan typically used by small businesses or self-employed individuals. It allows employers to make tax-deductible contributions on behalf of eligible employees, including themselves, to their individual retirement accounts.

How does a SEP IRA differ from traditional or Roth IRAs?

The main difference is in contribution limits and funding sources. SEP IRAs generally have higher contribution limits than traditional or Roth IRAs and are funded solely by the employer, not the employee. Also, SEP IRAs don’t offer Roth contributions and are tax-deductible for the employer.

What are the primary tax advantages of contributing to a SEP IRA?

Contributions to SEP IRAs are tax-deductible for the business, reducing the taxable income of the business. Additionally, earnings in a SEP IRA grow tax-deferred until withdrawal.

Who is eligible to open a SEP IRA – are there specific requirements for business owners or self-employed individuals?

Any business owner or self-employed individual can establish a SEP IRA. There are no specific requirements regarding the size or type of business.

What are the annual contribution limits for SEP IRAs, and how are they determined?

The annual contribution limit for SEP IRAs is the lesser of 25% of the employee’s compensation or a specific dollar amount set by the IRS annually. For 2022, the limit is $61,000.

Can employees contribute to their SEP IRA, or are contributions solely from the employer?

Contributions to SEP IRAs are made exclusively by the employer. Employees cannot make contributions to their SEP IRA accounts.

Are there any penalties for early withdrawal from a SEP IRA?

Yes, withdrawals from a SEP IRA before age 59½ typically incur a 10% early withdrawal penalty in addition to regular income tax on the amount withdrawn.

How does a SEP IRA fit into a broader retirement planning strategy?

A SEP IRA can be a significant part of a retirement strategy, especially for those looking for higher contribution limits than traditional IRAs. It’s suitable for small businesses and self-employed individuals as it’s easy to set up and maintain.

Can a business owner have both a SEP IRA and a traditional 401(k) plan?

Yes, a business owner can have both a SEP IRA and a 401(k) plan. However, contributions to both plans must stay within IRS-defined limits.

What are the key steps in setting up a SEP IRA for a small business or a self-employed individual?

Setting up a SEP IRA involves choosing a financial institution to administer the account, completing a formal written agreement to establish the plan, informing eligible employees about the plan, and then making contributions to the SEP IRAs of the eligible employees.

CONSULT WITH CREDO

At Credo, we specialize in guiding businesses towards effective retirement planning strategies, ensuring both the financial well-being of your employees and the long-term fiscal health of your company. Our expert team is well-versed in Simplified Employee Pension Individual Retirement Arrangements (SEP IRAs) and the various aspects of retirement planning, with a focus on maximizing tax benefits and other financial advantages. Let us assist you in understanding the intricacies of SEP IRAs and how they can be seamlessly integrated into your business’s financial planning, contributing to a prosperous future for both your employees and your organization.

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