The advantage of putting money into a Simplified Employee Pension (SEP) plan is the tax treatment afforded by an individual retirement arrangement. IRAs aren’t the only investment approach that provides tax advantages, however. The tax breaks that come with some investments don’t work the same way with SEP IRAs and you may end up paying more money to Uncle Sam as a result.
SEP IRAs allow small businesses and self-employed people to set up retirement plans without a lot of red tape. Each employee has her own SEP IRA account, which is actually a traditional IRA provided by the business. The employer makes all the contributions. An employer can add as much as 25 percent of an employee’s salary up to an annual dollar limit, which was $52,000 at the time of publication. Contributions are pre-tax, meaning the employee pays no income tax on money added to the SEP IRA. Investment earnings and contributions are tax-exempt until taken out of the account, when it becomes taxable.
Municipal bonds are a good example of a tax-free investment. Known as munis, they are sold by state and local governments. The interest they earn is typically exempt from federal income tax and frequently exempt from state and local income taxes as well. The common element you find in non-IRA tax-free investments is that the tax breaks come with the investment and don’t depend on the kind of account used to purchase them.
Investing in tax-free assets with a SEP IRA is the financial equivalent of shooting yourself in the foot. Every dollar you eventually take out of the SEP IRA is taxable as ordinary income. For example, the interest earned by a tax-free muni bought with non-IRA money is never subject to income taxes. If you buy the same bond with your SEP IRA, the interest it earns is taxed when you withdraw it from the account. The same holds true for any tax-free investment. Earnings that would not be taxable if made with non-IRA funds are taxable income when withdrawn if you use a SEP IRA for the investment.
The earnings from some investments are taxed as ordinary income when purchased with non-IRA money. For example, CNN Money suggests taxable corporate and Treasury bonds for IRA investing. Buying stocks you expect to hold for a year or less may make sense for a SEP IRA because the profits are taxed as ordinary income. Profits from stocks held for longer periods qualify for lower capital gains tax rates, an advantage you lose if the stock is held in a SEP IRA. The general rule of thumb is that the fewer tax advantages an investment has when made with non-IRA money, the better it is likely to be as a SEP IRA investment.
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