How Does a SEP IRA Work?

What is a SEP IRA?

A Simplified Employee Pension Investment Retirement Account, or SEP IRA, is a retirement account that self-employed individuals can set up for themselves or that small business can establish for the benefit of their employees. Using a SEP IRA can be advantageous for small businesses because it takes less effort and expense to manage than a 401k plan. The way a SEP IRA operates is similar to a traditional IRA in that the owner can invest funds and the amount of contributions can be deducted from taxes.

There are three main steps involved in setting up a SEP IRA. First, a formal written agreement must be composed, which is usually done with a standardized form the IRS provides. Second, eligible employees must be informed of the plan, usually by providing a copy of the form, and finally, the plan must be made available to each eligible employee. An eligible employee is defined as any person over age 21 that has worked for the company setting up the IRA for three of the five most recent years and has been paid at least $500 over the most recent tax year. The costs of setting up and managing a SEP IRA are relatively low, and the IRS may provide credit for start-up costs.

Contributions and distributions (withdrawals) to and from SEP IRAs are similar to traditional IRAs. Contributions by a self-employed individual to their own SEP IRA are tax deductible, as are contributions made to any employee's IRA accounts. Laws regulate the maximum amount of contributions to a SEP IRA. Visit SEPIRA.com to learn about the current limits. Distributions of money from SEP IRAs are subject to traditional IRA rules, meaning withdrawals before age 59 and a half carry tax penalties, and mandatory withdrawals are required starting at age 70 and a half. Additionally, withdrawals are subject to capital gains tax.