SEP IRAs, or “Simplified Employee Pension” plans are often the best choice for sole proprietors. Let’s take a look at why.
Any employer, including a sole proprietorship with one or more employees, can establish an SEP plan. SEP IRAs are created in the employer’s (your) name and only the employer can contribute. They are great for self-employed individuals because they are easy to set up -- just about every bank, mutual fund company, or brokerage firm will allow you to open one. Additionally, they are extremely affordable, generally charging low or no annual account fees. They are also far less complex than qualified plans, making them easier to use for individuals working on their own.
A major benefit of SEP IRAs is their flexibility. As a self-employed professional, you can contribute up to 25% of your net earnings from self-employment, up to a limit that increases with inflation ($53,000 in 2016). You do not have to contribute the same amount every year and do not need to fund the account until you file your tax return. For sole proprietors with fluctuating income, these capabilities are a major advantage, as you can contribute more in high earning years and less in others. And unlike regular contributions to a traditional IRA, you can contribute to your SEP IRA when you are over 70.5 years old. All contributions are tax-deductible and tax-deferred.
Employees are eligible to participate in a SEP IRA if they are 21 years old or over and have worked for the company for three of the last five years, receiving a minimum of $550 in compensation per year. Employers are not required to contribute to the SEP IRA, but if you do, you must also contribute to the SEP IRA of all your eligible employees. The same account to which SEP contributions are made can also be used for Traditional IRA contributions.
SEP IRAs are particularly well-suited for entrepreneurs who have no employees, significant income, and a preference for flexibility. If you decide that an SEP IRA is right for you, there are three basic steps to setting one up. First, you must execute a formal written agreement to provide benefits to all eligible employees. Secondly, you must give each eligible employee certain information about the SEP. Third, a SEP IRA must be set up by or for each eligible employee.
Employees have complete ownership over their funds, meaning they can take the contribution at any time, even if they no longer still work for the business. SEP IRAs do not allow loans, although you can withdraw money from the plan at any time (a 10% penalty may apply if you withdraw funds you are age 59.5).