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A Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is a variation of the Individual Retirement Account used in the United States. SEP IRAs are adopted by business owners to provide retirement benefits for the business owners and their employees. There are no significant administration costs for self-employed person with no employees. If the self-employed person does have employees, all employees must receive the same benefits under a SEP plan. Since SEP IRAs are a type of IRA, funds can be invested the same way as most other IRAs.
The deadline for establishing the plan and making contributions is the filing deadline for the employer's tax return, including extensions.
The most strict conditions for an employee to be eligible are as follows. The employee must:
- be at least 21 years of age
- have worked for the employer for at least three of the previous five years
- have received at least $550 in compensation for the tax year
SEP-IRA funds are taxed at ordinary income tax rates when qualified withdrawals are taken after age 59 1/2 (as for traditional IRAs). Contributions to a SEP plan are deductible, lowering a taxpayer's income tax liability in the contribution year.
SEP-IRA contributions are treated as part of a profit-sharing plan. For employees, the employer may contribute up to 25% of the employee's wages to the employee's SEP-IRA account. For example, if an employee earns $40,000 in wages, the employer could contribute up to $10,000 to the SEP-IRA account.
The total contribution to a SEP-IRA account should not exceed the lesser of 25% of income (20% for self-employed before self-employed tax deduction is included); (see below) or $42,000 (for 2005), $44,000 (2006), $45,000 (2007), $46,000 (2008), $49,000 (2009-2011), $50,000 (2012), $51,000 (2013), $52,000 (2014), and $53,000 (2015). For 2010 and 2011, the compensation used in the calculation was capped at $245,000 (e.g., an employer making a 10% contribution cannot contribute more than $24,500 for any employee).
The contribution limit for self-employed persons is more complicated; barring limits, it is 18.587045% (approximately 18.6%) of net profit. The computation is in IRS Pub 560, section 5, Table and Worksheets for the Self-Employed, specifically Deduction Worksheet for Self-Employed.
Two complications are:
- Federal Insurance Contributions Act tax (FICA)
- Reduced rate
SEP contribution limits are computed not from net profit but from net profit adjusted for the deduction for self-employment tax (2006 Form 1040, line 27, from Schedule SE, Section A, line 6, or Section B, line 13). Barring limits, this is half the 15.3% FICA tax, levied on net earnings, which is 92.35% of net profit. Therefore, adjusted net profit (net profit minus deduction for self-employment tax) is 92.935225% of net profit, which is close to but slightly more than net earnings.
The limit of 25% applies to wages, not (adjusted) net profit.
In the above example, where an employee earns $40,000 and the employer contributes 25% of that, $10,000, the employee has received $50,000 total, of which 20% goes to the SEP-IRA.
When a business is a sole proprietorship, the employee/owner both pays themselves wages and may also make a SEP contribution, which is limited to 25% of wages, namely, profits minus SEP contribution. For a particular contribution rate CR, the reduced rate is CR/(1+CR); for a 25% contribution rate, this yields a 20% reduced rate, as in the above.
Thus the overall contribution limit (barring limits) is 20% of 92.9% (that is, 18.6%) of net profit.
For example, if a sole proprietor has $50,000 net profit from self-employment on Schedule C, then the "1/2 of self-employment tax credit", $3,532, shown on adjustments to income at the bottom of form 1040, will be deducted from the net profit. The result is then multiplied by 20% to arrive at the maximum SEP deduction, $9,293.
Note that net earnings include the proposed deduction for contributions to your own SEP-IRA. In this example, the sole proprietor therefore has $59,293 in net income before his (maximum) SEP-IRA contribution.
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Why Choose a Solo 401(k) Plan Vs. a SEP IRA
A Solo 401(k) plan is an IRS approved retirement plan suited for business owners who do not have any employees, other than themselves and perhaps their spouse. The “one-participant 401(k) plan” or individual 401(k) Plan is not a new type of plan. It is a traditional 401k plan covering only one employee. Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) became effective in 2002, there was no compelling reason for an owner-only business to establish a Solo 401(k) Plan because the business owner could generally receive the same benefits by adopting a profit sharing plan or a SEP IRA. After 2002, EGTRRA paved the way for an owner only business to put more money aside for retirement and to operate a more cost-effective retirement plan than a SEP IRA or 401(k) plan. There are a number of options that are specific to Solo 401k plans that make them a far more attractive retirement option for a self-employed individual than a SEP IRA.
1.Reach your Maximum Contribution Amount Quicker: A Solo 401(k) Plan includes both an employee and profit sharing contribution option, whereas a SEP IRA is purely a profit sharing plan.
Under the 2015 new Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $18,000. That amount can be made in pre-tax or post-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $53,000, an increase of $1,000 from 2014.
For plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $24,000 in 2015. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $59,000, an increase of $1,500 from 2014.
Whereas, a SEP IRA would only allows for a profit sharing contribution. Hence, a participant in a SEP IRA would be limited to 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum of $53,000 for 2015. No employee deferral exists for a SEP IRA.
For example, Joe, who is 60 years old owns 100% of an S Corporation with no full-time employees. Joe earned $100,000 in self-employment W-2 wages for 2015. If Joe had a Solo 401(k) Plan established for 2015, Joe would be able to defer approximately $49,000 for 2015 (a $24,000 employee deferral, which could be pre-tax or Roth, and 25% of his compensation giving him $48,000 for the year). However, if Joe established a SEP IRA, Joe would only be able to defer approximately $25,000 (25% if his compensation) for 2015.
2.No catch-up Contributions: With a Solo 401K Plan you can make a contribution of up to $53,000 to the plan each tax year ($59,000 if the participant is over the age of 50). However, with a SEP IRA, the maximum amount that can be deferred is $52,000 since a SEP IRA does not offer any catch-up contributions.
3. No Roth Feature: A Solo 401k plan can be made in pre-tax or Roth (post-tax) formats, whereas, in the case of a SEP IRA, contributions can only be made in pre-tax format. In addition, a contribution of $18,000 ($24,000, if the plan participant is over the age of 50) can be made to a Solo 401(k) Roth account.
4. Tax-Free Loan Option: With a Solo 401k Plan you can borrow up to $50,000 or 50% of your account value what ever is less. The loan can be used for any purpose. With a SEP IRA, the IRA holder is not permitted to borrow even $1 from the IRA without triggering a prohibited transaction.
5. Use Nonrecourse Leverage and Pay No Tax: With a Solo 401(k) Plan, you can make a real estate investment using nonrecourse funds without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (IRC 514). However, the nonrecourse leverage exception found in IRC 514 is only applicable to 401(k) qualified retirement plans and does not apply to IRAs. In other words, using a Self-Directed SEP IRA to make a real estate investment involving nonrecourse financing would trigger the UBTI tax, which is approximately 35%.
6. Better Creditor Protection: In general, a Solo 401(k) Plan offers greater creditor protection than a SEP IRA. The 2005 Bankruptcy Act generally protects all 401(k) Plan assets from creditor attack in a bankruptcy proceeding. In addition, most states offer greater creditor protection to a Solo 401(k) qualified retirement plan than a SEP IRA outside of bankruptcy.
The Solo 401k plan is unique and so popular because it is designed explicitly for small, owner only business. The many features of the Solo 401k plan discussed above is why the Solo 401k Plan or Individual 401k Plan it so appealing and popular among self-employed business owners.
- "IRS Pub 560 (Retirement Plans for Small Business - SEP, SIMPLE, and Qualified Plans)" (PDF). irs.gov.
- Bergman, Adam. "Solo 401(k) Advantages". Adam Bergman, Esq. Retrieved 9 January 2015.
- Bergman, Adam. "Solo 401(k) Plan How It Works". Adam Bergman, Esq. Retrieved 9 January 2015.
- Bergman, Adam. "Solo 401(k) Plan". Adam Bergman, Esq. Retrieved 9 January 2015.
- Bergman, Adam. "Solo 401(k) Solution". Adam Bergman, Esq. Retrieved 9 January 2015.
- Bergman, Adam. "Solo 401(k) Loan". Adam Bergman, Esq. Retrieved 9 January 2015.
- Bergman, Adam. "Solo 401(k) Plan Purchase Real Estate". Adam Bergman, Esq. Retrieved 9 January 2015.
- Bergman, Adam. "Solo 401(k) Plan Asset and Creditor Protection". Adam Bergman, Esq. Retrieved 9 January 2015.