What Is A SEP IRA And How Can It Lower Your Tax Liability This Year?

Chances are you’ve probably heard that SEP IRA’s are helpful for business owners looking to invest as well as lower their tax liability. But what exactly are they and how do they work?

A SEP IRA is a Simplified Employee Pension Individual Retirement Account. This is essentially a traditional IRA but for self employed people and small business owners. Meaning that these are special tax advantaged investment accounts that are allowed by the IRS for business owners to invest their money as well as gain tax benefits for doing so. Contributions into these accounts generate a current year tax deduction for the business owner and the investments grow until the business owner retires and then withdraws the funds and takes them as taxable distributions from the account.

The play here is that you lower your taxes at your current marginal rate, assuming it is higher than it will be when you plan to retire, and then pay tax on your investment returns at your future lower marginal tax rate. This is true for most people as they tend to reduce their earning efforts in their later age as they shift their focus away from their careers and more towards rest and family time.

But who is eligible to use a SEP IRA? This tool works best for small business owners with few or no employees. If you have employees considered “eligible participants” by the IRS, you are responsible for offering them the same IRA as you and even contributing to it on their behalf and these contributions have to be an equal percentage of compensation as your own. Meaning if you contribute 20% of your compensation to a SEP IRA, you have to contribute 20% of each of your eligible employee’s compensation to their accounts as well. Eligible participants are defined by the IRS as an individual's age 21+, who have worked for the employer in at least 3 of the last 5 years, have received at least $650 in compensation for 2021 (or $600 in 2019 and 2020).

A key benefit to utilizing a SEP IRA versus just a normal traditional IRA is the difference in contribution limits (AKA the size of your deduction!). A normal IRA limits you to about $6,000 each year and $7,000 if you’re age 50+. SEP IRA’s allow you to contribute $58,000 (in 2021), however this limit cannot be greater than the lessor of 25% of compensation or the $58,000. The 25% limit also applies to how much you can contribute on the behalf of your employees as well. The limit of compensation to calculate the 25% limit is $290,000 in 2021.

To actually take advantage of a SEP IRA and start one, you must select a provider/brokerage firm that offers SEP IRA’s and apply to open one with them. Once that is complete, according to the IRS you must create a formal written agreement that states your businesses policy on offering the SEP IRA to its employees as well as the contributions that you plan to make. This agreement must be made available and distributed to all employees at your business. Then you must open accounts for each employee who opts in and let them operate their account and contribute on their behalf.

To learn how your business specifically can benefit from a SEP IRA please reach out to us, we would be happy to answer any questions.