Sep Iras: a Path to More Retirement Income?

A SEP IRA is a plan that may allow you to put away more tax deductible dollars for retirement. For employers, SEPs are a simple way to establish a retirement plan for employees without many of the restrictions that apply to other qualified plans and without the mounds of paperwork.

Here, however, we are going to talk about how a SEP IRA could allow you to save more for retirement if you have self-employment income outside of your job or have your own business. Business owners are both “employers” and “employees.” For this discussion, we will assume that you are the only employee.

Note: If you are involved in a business with partners or employees, the same percentage contribution is required for all employees who are over age 21, have worked in the business in at least three of the last five years and made at least $450 (2006). Other technicalities may apply.

The Rules

1. You can contribute up to 25% of your compensation, subject to a maximum. This maximum is indexed; for 2006 it was $44,000 and for 2007 $45,000.

2. Assuming the SEP IRA’s tax year is the calendar year, contributions can be made up until April 15th of the following year, when the tax return is due.

3. You can contribute up until you are 70 1/2, but not beyond.

4. Withdrawals before age 59 1/2 are subject to the 10% premature distribution penalty tax unless one of the exceptions apply.

5. You have to start taking the money out (RMDs) at age 70 1/2.

The Benefits

1. SEP IRAs are simple. Essentially SEPS are big IRAs. There is very little paperwork.

2. They are flexible. You can vary the amount you contribute each year from zero all the way up to the year’s maximum contribution limit.

3. The total contribution limit is indexed which allows more to be contributed each year.

4. Employer contributions are generally not subject to FICA (Social Security tax), FUTA (federal unemployment tax) or income tax withholding.

5. As an employee of your SEP IRA, you possibly can make deductible contributions as well. These contributions have the same contribution limits as traditional IRAs. For 2006 and 2007, this is $4,000. If you are age 50 or over, you can add another $1,000. However, if you make too much money, your contribution maximum is either reduced or eliminated.

6. You can be a participant in a qualified plan (for example, a 401(k)) at work and still be able to contribute to your SEP IRA based on your outside income. Again, this is a function of your income and subject to the phase out rules discussed below.

Phase-Out Rules

1. First, these rules apply if you are a participant in another qualified plan. Note that having a SEP IRA puts you in this category.

2. Your income and your tax filing status determine the phase-out. Technically, this is “modified adjusted gross income” (MAGI) which is adjusted gross income with certain adjustments. See your accountant.

3. If you file a joint tax return and have a MAGI of $75,000 or less (2006), you can make a full employee contribution: $4,000 or $5,000 if you are 50 or older. If your MAGI is over $85,000, no contribution can be made. A partial contribution formula determines the maximum permissible contribution for incomes between $75,000 and $85,000.

4. If you file a single tax return, you can make a full SEP IRA employee contribution if your MAGI is $50,000 (2006) or under and no contribution for incomes of $60,000 (2006) or more. Again, for incomes between these numbers, a formula determines a partial contribution limit.

5. If you are married and file a separate return, the phase-out starts at an income of zero. Adjusted gross income of $10,000 or more does not allow any contribution.

These benefits and rules of SEP IRAs are based on my understanding and cannot be used as tax advice. The proper plan will depend on your goals, income, tax filing status, and your participation in another qualified plan. It would be best to sit down with your accountant and financial planner and do the math on all your options.

Robert D. Cavanaugh, CLU