A simplified employee pension, or SEP IRA, is a type of retirement account that an employer can set up for employees. It's often used by small businesses. Only employers, not employees, contribute to a SEP IRA, but once the money is in the account, it's governed by essentially the same rules as a traditional IRA. That means that penalties for early withdrawal can apply, and penalties are imposed for failing to follow SEP IRA mandatory withdrawal rules after age 70 1/2.
You can withdraw money from a SEP IRA, but if you do so before you reach age 59 1/2, you might owe a tax penalty unless special circumstances apply. You can also roll money over from a SEP IRA to another retirement plan without tax penalties.
Understanding How SEP IRAs Work
A SEP IRA is a type of retirement plan that a company can set up for its employees. Self-employed people and company owners and managers can contribute to their own accounts through their businesses, but employees can't contribute directly to their SEP IRAs. Employers normally get a tax deduction for contributing to the SEP IRA, and employees aren't taxed on those funds until they withdraw them, such as in retirement. In some cases, a SEP plan may be able to put funds into an existing traditional IRA account.
A business can choose how much to contribute to employee SEP IRAs each year, including not making any contribution if the business isn't doing well, as long as they stay within Internal Revenue Service rules. Once money is put into the SEP IRA, it is considered fully vested, meaning it is immediately within the control of the employee who received it. Employees generally control how the money gets invested within the rules set up by the financial institution that manages the accounts.
Following SEP Withdrawal Rules
Once funds are in a SEP IRA, the accounts generally follow the same rules as a traditional individual retirement arrangement. That means that when plan participants withdraw money from their accounts, they pay ordinary income tax on the amount they withdraw, and if they withdraw funds before the IRS retirement age of 59 1/2, they owe an additional 10 percent tax penalty.
That penalty can be waived if the money is used for certain approved purposes, including buying health insurance while unemployed, paying for certain educational expenses for the account holder or a relative or paying for certain costs when called up to active duty from the military reserves. There's also a special allowance for first-time homebuyers to take $10,000 from SEP IRAs and traditional IRAs to use toward the purchase of that house. Check with tax advisers or consult the latest IRS publications if you're not sure whether your withdrawals will see a tax penalty.
You can also roll money over from a SEP IRA to another traditional IRA. Generally, you'll want to have the two financial institutions work together so that you don't take direct possession of the money to avoid owing tax. If you must briefly hold the funds, you may owe tax if you do so for longer than 60 days.
SEP IRA Mandatory Withdrawal Rules
As with traditional IRAs, you must start making withdrawals from SEP IRAs by the time you reach age 70 1/2. You can find a traditional IRA withdrawal tax calculator tool online to help you optimize your withdrawals to meet IRS minimums and minimize your total tax bill.
If you don't take the mandatory withdrawals, often called required minimum distributions, you can be taxed up to 50 percent of the difference between what you were required to withdraw and what you actually withdrew.
SEP IRA Alternatives
SEP IRAs are similar to another kind of employer-sponsored retirement plan called a SIMPLE IRA, although those also allow for employee contributions and have some other differences from SEP IRAs. Self-employed people can normally also choose between contributing to SEP IRAs for themselves, traditional IRAs and Roth IRAs.
If you're an employer choosing between SEP IRAs, SIMPLE IRAs and other options like 401(k) plans, you may want to consult a tax advisor or lawyer for guidance.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.