Retirement can conjure up visions of perfecting your golf swing, hanging with the grandkids or taking epic vacations.
But the ability to do just as you please requires financial freedom—in other words, a sizable nest egg.
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Clients regularly ask me about potential savings vehicles such as 401(k)s and IRAs—but people also hear about other retirement accounts and wonder whether they’re missing out on potential financial benefits.
That’s why I sometimes get asked: “What’s a SEP IRA?”
Why So Many People Ask This Question
The SEP IRA isn’t a well-known entity. And that’s largely because it usually makes sense only for a subset of retirement savers, namely, small business owners and self-employed people with non-W-2 income.
For the right candidates, though, there’s a powerful case to make for SEP IRAs, as long as you understand the fine print.
What I Tell Them
The advantages of the SEP IRA are strong. For starters, it lets you set aside up to 25% of your income (up to $53,000) annually. Traditional IRAs, in comparison, limit you to $5,500 to $6,500, and 401(k)s cap at $18,000 to $24,000.
The contributions come out of your pretax income, and you don’t pay income taxes on the money until you begin to withdraw it after age 59½.
Another giant plus, particularly if you’re prone to upward and downward income swings, is that there are no required annual contributions. That means if you’re having a bad year, you can choose to set aside $0 in the SEP—and then pick it back up once the cash starts flowing in steadily again.
Administrative costs for SEP IRAs tend to be much lower than those of traditional employee retirement plans. If you own a business, you’d likely have your CPA handle filling out the necessary 5305-SEP IRS form and other paperwork; no third-party administrator is needed.
Related: IRAs: Everything You Need to Know for 2015
But the drawbacks of SEP IRAs can be equally striking. First and foremost, if you’re an employer, contributions for workers come out of your own pocket—not theirs. Employees can’t contribute their money to SEP IRAs, so it’s essentially your gift.
For small business owners, the SEP has one contribution rule that’s particularly rigid: You have to contribute the same percentage for each employee—you can’t kick in 10% for a new hire while rewarding a longtime worker with 25%.
Even if you’re a freelancer or sole proprietor and only contribute for yourself, you need to rake in serious revenue to take full advantage of the 25% max contribution. Few people can afford to save $1 out of every $4 they earn. For this reason, it’s usually those who make more than $200,000 a year who gravitate toward a SEP.
The Bottom Line
A SEP IRA tends to cater to individuals who are self-employed or run a small business. It’s an especially attractive retirement savings option for high earners who have cash left over after paying their bills and can put aside a significant amount of pretax income.
