Advantages & Disadvantages of a SEP IRA

If you understand SEP IRAs, you can create a retirement nest egg.

If you understand SEP IRAs, you can create a retirement nest egg.

You can invest for retirement in a Simplified Employee Pension plan as an employee of a business that offers this plan or as a self-employed person. The SEP IRA offers features that benefit people who decide to contribute large amounts to retirement savings. If you weigh the advantages of a SEP IRA against its disadvantages, you can make an informed decision that fits your particular needs.

High Contribution Limit

As of the 2012 tax year, you can set aside up to $50,000 per year in a SEP IRA. That limit applies to each employee and to yourself. The amount cannot exceed 25 percent of income. For example, a person making $100,000 could set aside $25,000 a year, because that is 25 percent of wages. This high limit makes the SEP IRA attractive when compared to other IRAs, although the Individual 401(k) has the same limit.

No Catch-up Provision

The SEP IRA does not allow people older than 50 to make additional contributions. Other retirement accounts allow for "catch-up" contributions. However, as of 2012, traditional IRAs and Roth IRAs carry a limit of $5,000 in annual contributions, so the SEP IRA limit of $50,000 more than makes up for the lack of a catch-up provision. SIMPLE IRAs allow for an additional contribution of $2,500 after age 50, but the initial limit is $11,500, so the SEP IRA still allows for a greater contribution. However, the Individual 401(k) allows $50,000 per year in contributions plus a catch-up contribution of $5,500 for people older than 50.

Tax-deferred Savings

The person making the contribution to SEP IRA savings does not have to pay taxes on the money in the current year. When that person withdraws funds at retirement, she will pay taxes at that point. For example, a person whose income is $50,000 could contribute $10,000 to a SEP IRA and only owe taxes on $40,000 of earnings. This can save money on actual taxes paid if you have a lower tax rate during retirement than you do during your working years.

No Borrowing

If you or an employee need emergency funds, you cannot borrow against the money in your SEP IRA. If you want the money anyway, you would have to withdraw it and pay a penalty if the withdrawal occurs before you are 59-1/2. Other IRA accounts allow emergency withdrawals for medical situations and education payments. These exceptions do not apply to SEP IRA account holders.

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