Of the different types of tax-qualified retirement plans available to small businesses, a SEP-IRA has the potential for significantly large contribution amounts. The U.S. Department of Labor promotes SEP-IRA plans as an easy and low-cost way to start a company retirement savings plan. If you are self-employed, a SEP-IRA may be a very attractive retirement savings option. If you work for someone else, the terms of the plan are out of your control.
To start a SEP-IRA plan, an employer starts a separate individual retirement arrangement -- IRA -- for each employee of the business. Only the employer makes SEP-IRA contributions into the plan and gets the tax deduction for the contributions.
Individual employee contributions are a percentage of annual wages set each year by the employer. As an employer you can't defer wages into their individual SEP-IRA accounts. If the SEP-IRA allows, an employee can make a regular IRA contribution into the same account and take the IRA tax deduction.
All employees of a business, full-time and part-time, must be included in the plan.
The maximum SEP-IRA contribution limit is 25 percent of an employee's salary. Each year the employer chooses any percentage from zero up to 25 percent. All employees of the business will receive the same percentage of wages deposited into their SEP-IRA accounts. The tax rules put a limit on wages that can be used to calculate the SEP-IRA contribution. For 2013, the salary limit is $255,000. If you were fortunate enough to earn $300,000, your contribution percentage is still calculated on the $255,000 limit.
Tax rules also put a dollar cap on the annual contribution for defined contribution retirement plans, including a SEP-IRA. For 2013, the contribution cap is $51,000. The dollar contribution limit adjusts each year for inflation. The dollar cap also applies to all defined contribution plans your employer may have. So if another plan is also available, the total contributions for an individual employee cannot exceed $51,000.
If you are self-employed and file taxes as such, you must calculate the SEP-IRA contribution limit a little differently. Net income for a self-employed person is adjusted due to the self-employment tax you must pay, resulting in a contribution limit of 20 percent of net income for a SEP-IRA. The fact that SEP-IRA rules require an employer to fund employee accounts at the same percentage can result in more of the SEP-IRA contributions going to employee accounts rather that the business owner's SEP account. So this type of retirement account provides greater tax-deductible savings to the solo self-employed business without employees, where you -- the self-employed tycoon -- can set aside and deduct 20 percent or 25 percent of the business income.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.