Simplified employee pension plans (SEP-IRAs) provide self-employed individuals and small business owners with a way to save for retirement. In order to participate, the business owner and each eligible employee must open an individual SEP-IRA account at a bank or other qualified financial institution that offers retirement plans. Despite a SEP-IRA being easy to set up and maintain, there are some disadvantages.
Employee Contributions Not Allowed
Unlike a SIMPLE IRA that allows both the employer and employees to make contributions to a traditional IRA retirement account, a main disadvantage of the SEP-IRA is that only the employer can make contributions to the plan. Employees are not allowed to contribute any funds to the account. Self-employed individuals or owner-employees who earn income can contribute to the SEP on their own behalf. The contributions an employer makes can vary from year to year and are based on a percentage of an employee’s earnings. All eligible employees must receive the same percentage. In comparison, a SIMPLE IRA plan offers more options. Under this type of retirement account, an employee makes contributions to the plan. An employer then has the option of making matching contributions.
While the SEP-IRA may involve fewer administrative costs, other types of retirement accounts allow a greater annual contribution for the same amount of income. As of the time of publication, the maximum allowable contribution to a SEP-IRA is $49,000. Under IRS rules, self-employed individuals and owners of businesses can contribute up to 25 percent of W-2 earnings or 20 percent of net self-employment income up to the limit. Another disadvantage of the SEP-IRA is that there is no provision allowing for an additional catch-up contribution for individuals ages 50 and older.
Unlike other retirement plans, such as the individual 401(k), the SEP-IRA does not give you the option of borrowing against your retirement plan. For example, the individual 401(k) allows you to use the account’s balance as collateral so that you can take out a loan. In the case of a 401(k), you can borrow up to half of the plan’s value, up to a maximum amount of $50,000.
Advantages to Employers
One advantage of the SEP to employers is that the employer may elect not to make contributions to the plan in years when business profits are down. Employers also determine how much to contribute, although the percentage of contributions must be based on an employee’s earnings and equal for all eligible employees. Contributions to an SEP pension plan are tax deductible for employers. In addition, business owners often qualify to receive a tax credit for expenses incurred to set up the plan. In some cases, a small business owner can deduct plan expenses, including contributions made to the plan.