SEP IRA

The SEP IRA is an easy to administer retirement plan designed to benefit self-employed individuals and small business owners who employ others. SEP/IRAs allow you to make tax-deductible contributions for yourself and your employees, providing flexibility in terms of the amount and timing of contributions. In addition, they are easy to administer, as we do most of the work. Sole proprietorships, S and C corporations, partnerships and LLCs all qualify for this type of plan qualify. If you are a sole proprietor you should also consider the Solo(k) which has advantages over the SEP/IRA.

SEP IRA contribution limits

In 2009 a SEP IRA has a contribution limit of $49,000 ($46,000 in 2008). The maximum annual compensation on which contributions can be based is $230,000 for 2008 and $245,000 for 2009. For self-employed people, compensation means earned income.

Contributions to a SEP IRA are generally 100% tax deductible and investment earnings in a SEP IRA grow tax deferred. Withdrawals after age 59 1/2 are taxed as ordinary income. Withdrawals prior to age 59 1/2 may incur a 10% IRS penalty as well as income taxes.

A SEP IRA has broad appeal due to its high annual contribution limits, the fact that annual contributions are flexible and completely discretionary and because it requires minimal administration.

Most frequently a SEP IRA is established by a business owner with no employees and is discussed in detail below.
In special situations a SEP IRA may be an ideal retirement plan for a business owner with employees.

SEP IRA for a self-employed business owner without employees

The calculation of how much can be contributed to a SEP IRA is dependent on whether your business is a corporation and you receive a W-2 as compensation or if you are taxed as a sole proprietorship and receive compensation as personal income. Examples of both are shown below.

Employed individual receives W-2 form business (Employer)

An S or C corporation, an incorporated partnership or a LLC electing to be taxed as a corporation pays the business owner a W-2 salary. In this situation, the annual SEP IRA contribution can be between 0% to 25% of the owner's W-2 salary up to the SEP IRA contribution limit (2009 limit is $49,000 on maximum income of $245,000). SEP IRA contributions are generally 100% tax deductible as a business expense.

Business owner receives compensation as personal income

When a SEP IRA is established for a unincorporated business such as a sole proprietorship, unincorporated partnership or a LLC electing to be taxed as a sole proprietorship, annual contributions are made into your SEP IRA account between 0 to 20% of your net adjusted self employment income (or net adjusted business profits). Compute the amount using the following formula: Compensation (before subtracting employer SEP contributions) X 20%. SEP contributions are flexible and the percentage of contribution can be changed at any time and may be skipped by the employer in any given year. SEP IRA contributions are generally 100% tax deductible from personal income.

What are the SEP IRA setup and contribution deadlines?

Generally a SEP must be established and funded by your tax-filing deadline (for corporations that would be March 15th unless there was an extension until September 15th). Generally, filing extensions extends the period for establishing and funding the SEP plan. For a sole proprietor April 15th would be the deadline to establish and fund a SEP for the prior tax year. If an extension was filed a sole proprietor can establish and fund a SEP IRA by October 15th.

A self-employed business owner with no full time employees other than a spouse may also want to consider a Solo(k) as well as a SEP IRA.

A SEP IRA allows a contribution of up to 20% of net self-employment income or 25% of W-2 wages, but a Solo(k) frequently permits a larger contribution at the same income level and may allow a greater contribution.
Another feature of a Solo(k) versus a SEP IRA is a Solo(k) permits a loan up to 1/2 the value of the account up to a maximum of $50,000.
A Solo(k) also allows investments in real estate using leverage without incurring unrelated business income tax on the debt-financed earnings.
A Solo(k) also has a Roth contribution feature which allows contributions of up to $16,500 after-tax (regardless of income, unlike a Roth IRA) or $22,000 if you are over 50 (for 2009).

SEP IRA vs. Solo(k): Which self-employed retirement plan is better for you?

Selecting the right retirement plan can be confusing and the subtle differences between options can sometimes be overlooked. If you are a self-employed individual or an owner and spouse business and are considering a SEP IRA or Solo(k) reading this information should help you make your decision easier by explaining the differences simply.

The SEP IRA and Solo(k) are the two most common retirement plans chosen by successful self-employed individuals and owner and spouse businesses due to their high contribution limits and flexible annual contributions. The SEP IRAs only advantages over a Solo(k) are that it is easier to administer and it is less expensive to maintain. Solo(k) plans have greater administrative responsibilities than a SEP, but may allow a larger annual contribution at identical income levels due to the way the annual contribution is calculated. In addition, depending upon the saving and investment approaches undertaken, the Solo(k) has several features that a SEP IRA does not.

For example, IRS rules do not permit a loan from a SEP IRA, but a Solo(k) loan of up to half of the plan's value up to a $50,000 maximum is allowed. Also, a Solo(k) has a $5,500 catch up contribution for those over 50. As a result, someone over 50 can save up to $54,500, whereas the same individual would be limited to $49,000 with a SEP IRA.

The Solo(k) allows one to invest in real estate and use leverage and be exempt from UBIT (Unrelated Business Income Tax). A SEP IRA using leverage is subject to UBIT.

It is important to note that you can set up a SEP IRA and convert to a Solo(k) in the future if you change your mind and either want to receive a Solo(k) loan or if you want to contribute more than the calculations of a SEP IRA will allow. Converting from a SEP IRA to an Solo(k) and transferring retirement assets from a SEP IRA to a new Solo(k) can be accomplished by completing some minor administrative paper work (just call (800) 969-4472 and Customer Service will assist you).

The Solo(k) and the SEP IRA have comparable maximum limits, but due to the way the contribution is calculated a self-employed individual may be able to contribute more into a Solo(k) versus a SEP IRA at the same income level, therefore maximizing retirement contributions and valuable tax deductions.

Here's how the calculation works. In 2009, participants in a Solo(k) can contribute up to 100% of the first $16,500 ($22,000 if age 50+) of W-2 compensation or net self employment income for a sole proprietorship. In addition, a profit sharing contribution can be made up to 25% of W-2 wages or 20% of net self employment income. The contribution limit calculation in a Solo(k) is important because it allows you to potentially save more than a SEP IRA at the same income level.

The Roth feature of PENSCOs Solo(k) is very important. With the passing of the Pension Protection Act of 2006, individuals can now put away up to $16,500 ($22,000 if over 50) each year on an after-tax basis that will then grow tax-free for their lifetime and possibly that of their heir(s). Unlike a Roth IRA, this option is available regardless of the income level of the Solo(k) participant. Better yet, when leverage is used to buy real estate with the Roth contributed funds; there is never any tax on the debt-financed income! The Roth feature is not available with a SEP IRA.

Summary

If you don't invest in real estate using leverage; don't need to borrow money from your pension plan; can't put away more than $49,000 in plan savings each year, and don't want to create tax-free savings through the Solo(k) Roth feature; then the SEP IRA is a better choice. If you need any of these features, then the Solo(k) is the better choice. The choice is yours at PENSCO, as we offer both plans.