SEP IRA Rules and Contribution Limits Explained

SEP IRA Rules and Contribution Limits Explained January 5, 2012

One of the best ways for a self employed business owner to save for retirement is to open a SEP IRA.  SEP (Simplified Employee Pension) IRAs give small business owners the flexibility they need to save for retirement without the headaches of administering a solo 401(k) plan.

The SEP IRA rules and contribution limits are very easy to understand, especially if you’re familiar with the 401(k) and IRA contribution limits and rules.

SEP IRA Eligibility

An eligible employee must meet the following requirements according to the IRS (publication 560):

–       Has reached age 21

–       Has worked for at least 3 of the last 5 years

–       Has received at least $550 in compensation in the tax year 2011.

SEP IRA Contributions Limits 2012

How much can I contribute to a SEP IRA?

Contribution to a SEP IRA must come from an employer.  (If you are self-employed, you can contribute to your own SEP IRA.)  The maximum SEP IRA contribution that can be made for an eligible employee is limited to the following: $49,000 or 25% of employee’s compensation.  For sole proprietors, the maximum SEP IRA contribution is limited to $49,000 or 20% of your compensation

I also have a 401k I’m contributing to at work.  Does this affect my contribution limit?

Yes, if you are participating in a defined contribution plan like a 401(k) or a 403(b) through the same employer sponsoring your SEP IRA, you must add your contributions made to all defined contribution (DC) plans you have.  Since a SEP IRA is considered a DC plan for this limit, your contribution to a SEP IRA needs to be taken into consideration when calculating your maximum 401(k) or 403(b) contributions according to the IRS.

From the IRS:

Are there other limits on contributions?

Yes, if an employer contributes to another defined contribution plan for its employees, for example, a 401(k) plan, an annual addition limit applies. The annual addition limit is the lesser of $49,000 for 2011 and $50,000 for 2012 (subject to annual cost-of-living adjustments for later years) or 100% of the employee’s compensation. In determining this limit, contributions for employees to all defined contribution plans of the employer, which includes SEPs, must be included.

Can I still contribute to an IRA when I have a SEP IRA?

The employer contributions to a SEP IRA do not interfere with contributions made to a Roth or Traditional IRA.  This means that you can still have a Roth or traditional IRA if you are receiving contributions into a SEP IRA through your employer.

Important note for employers

You don’t have to make contributions each year, but when you do make a contribution, it must be for all employees who worked that year.  This includes employees who die or are terminated before the contribution is made.  Read more of this on page 6 of IRS publication 560.

Deducting SEP IRA Contributions

If you are self-employed, you can deduct the contributions you make each year to your SEP- IRA.  If you are a business owner, you can deduct the contributions made to each employee’s SEP-IRA as well.

SEP IRA Distribution Rules

Distributions from SEP IRAs are subject to RIA rules.  This means that a penalty of 10% will be issued for withdrawals made before age 59 ½.  The RMD (required minimum distribution) must be followed for account holders who are over age 70 ½.  There is, however, a special provision with SEP IRAs that allow employers to make contributions even if the employee is past age 70 ½.  The employee still takes an RMD, but as long as they receive compensation from the employer, they can get a SEP IRA contribution.

Opening a SEP IRA

Most financial institutions will help you set up a SEP IRA for your small business, so contact a financial advisor or retirement specialist to see how they can help you.

In general, you need to do three things when setting up a SEP IRA:

  1. Create and execute a formal written agreement that outlines the retirement benefits.
  2. Inform eligible employees of the SEP IRA plan by providing form 5305-SEP
  3. Establish a SEP IRA for eligible employees.

Do you have a small business?  Are you taking advantage of the high contribution maximums of a SEP IRA plan?

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