If you’re a freelancer or you run your own business, odds are you’ve heard about SEP IRAs, which are individual retirement accounts for self-employed individuals and small-businesses owners. A simplified employee pension (SEP) IRA gives you the ability to save for retirement while lowering your taxable income.

According to a survey by small-business site Manta, of the 66% of small-business owners who have a retirement plan, about 1 in 10 have a SEP IRA. Experts predict contract and freelance workers will make up half the workforce within the next 10 years.

Who can get a SEP IRA?

If you have freelance income, are a sole proprietor, or own a business with one or more employees, you can open a SEP IRA. If you’re a business owner and you open a SEP for yourself, you must open a SEP for each eligible employee.

According to the IRS, an eligible employee is anyone who is at least 21 years old, has worked for the same employer for three of the previous five years, and has received at least $600 in compensation from that employer during the current year. Employers can offer accounts to employees who don’t meet all the criteria, but they can’t withhold an account from any employee who does meet the criteria.

If a business owner offers a SEP IRA to employees, all contributions are funded by the employer — not by the employees.

Employee SEP IRA contribution limits

You can save up to 25% of your gross annual salary if you’re self-employed. That typically comes out to about 20% of your adjusted net earnings from self-employment, up to a maximum of $56,000 in 2019 (or $55,000 in 2018). You can calculate your sole proprietor contribution here.

SEP IRA contribution limits may hamper how much you can save toward retirement compared to other types of accounts — but that depends on your income and how much you wish to save. In nearly all cases, you’ll be able to save more with a solo 401(k), but you’ll first need to understand if you can save more than the SEP will allow.

“If someone is self-employed, they could be limited in their SEP contribution,” said Ted Toal, a financial planner in Annapolis, Md. “If they want to save more but the SEP formula doesn’t allow them to, they should instead look to open a solo 401(k).”

Here’s how the plans compare for a 40-year-old sole proprietor:

Employer SEP IRA contribution limits

If you are a business owner, you must save the same percentage of compensation to both your plan and your employees’ plans. Additionally, you must save the lesser of 25% of each worker’s compensation or $56,000 in 2019 (or $55,000 in 2018). When calculating your contribution limit, do not count any compensation over $280,000 for 2019 (or $275,000 in 2018) or your SEP contribution.

Although you must save the same percentage to each employee’s account, you may change the percentage from year to year. As an added bonus, employer contributions to employee SEP accounts are 100% deductible as a business expense.

SEP IRA tax and withdrawal rules

Like an employer-sponsored 401(k) plan, your contributions to a SEP IRA are pre-tax, lowering your taxable income for the year you contribute. Your money (hopefully) will grow over time in the SEP IRA, and when you’re ready to withdraw the money during retirement, you’ll be taxed on distributions (based on your tax bracket at the time of withdrawal).

If you withdraw any funds before the age of 59 and a half, you’ll pay a penalty on top of taxes for the withdrawal. Once you reach the age of 70 and a half, you must start taking distributions, even if you aren’t retired yet. “For an owner who is over 70 and a half but still working, they don’t avoid the required distribution in the SEP IRA,” said Toal. “You always have to take it once you’re over 70 and a half.”

How to open a SEP IRA

Opening a SEP IRA is fairly simple, and typically there are no fees to establish the account. Here’s what you should know about opening a SEP IRA:

• You can open a SEP IRA at any point up to your tax-filing deadline for that tax year, including extensions. “You have until October of the following year if you file an extension,” said Toal.
• Find a reputable provider to work with, such as a brokerage firm or mutual fund company. Some examples include Vanguard, Fidelity and TD Ameritrade.
• Most providers have a website where you can quickly and conveniently fill out a quick online application.
• Once your account is established and funded (which may take a couple of business days) it’s time to choose your investments. The right investment mix for you will depend on your age and risk tolerance. Consider a balanced fund or target-date retirement fund that will conservatively grow as you approach your retirement date.

Is a SEP IRA right for you?

A SEP IRA is one of the simplest retirement accounts for freelancers or business owners to open, and it may allow you to save enough to live comfortably during retirement. “It’s very easy to administer in comparison to employer sponsored plans like 401(k)s,” explained Darin Shebesta, a financial planner in Scottsdale, Ariz.

That being said, if you’re a sole proprietor with modest income, you may find a SEP IRA is limiting in terms of its allowable contributions. In the short term, you can separately fund a Roth or traditional IRA for an additional $6,000 a year if you’re under the age of 50 or $7,000 if you’re 50 years of age or older in 2019 (or $5,500 and $6,500, respectively, in 2018). If you have grander savings aspirations, a solo 401(k) may be a better solution for you.

You can open a solo 401(k) only if you’re a sole proprietor or if your only employee is your spouse. It’s also worth noting that you can take out a loan from some solo 401(k)s, which isn’t possible with SEP IRAs.

If you have employees, a SEP allows you to make contributions for your workers without the hassle of administering a 401(k) plan. But you must contribute the same percentage amount for your employees as you do for yourself. If you wish for employees to make their own contributions or would prefer to contribute a different amount toward your own retirement than toward your employees’ accounts, consider researching a savings incentive match plan for employees (SIMPLE) IRA or traditional 401(k) plan.

Bottom line

It’s important to keep in mind that whatever account you open, it isn’t a life sentence and can be changed later. “I’ve had clients who started out doing a traditional IRA,” said Marguerita Cheng, a financial planner in Potomac, Md. “Their business grew, and they did a SEP IRA, and then their business really grew, and they did a solo 401(k). Their needs changed as their business grew.”

If you’re just starting out, a SEP IRA can be an easy way to sock money away for retirement while also providing a tax break. It’s also a nice benefit to your employees. “It provides a lot of flexibility,” said Cheng.