What are the Disadvantages of the SEP-IRA?
As with any financial tool, there are advantages and disadvantages to using it. So, what are the disadvantages of the SEP-IRA?
Disadvantages of the SEP-IRA
SEP-IRA stands for Simplified Employee Pension Individual Retirement Plan. It is a simple and easy to administer type of retirement account that combines some of the appeal of a profit sharing plan and a pension plan and puts them within the reach of the small business owner and the self employed worker. They function in much the same manner as a Traditional IRA as far as taxation issues go and are subject to strict limitations on who can participate and what the maximum contributions per year can be.
Many people see the restrictions on contributions as a disadvantage of the SEP-IRA. The Internal Revenue Service monitors and restricts all IRA plans regardless of type because of the tax implications of them. However, the fact that contributions to the plan, which come directly from the employees earnings and are paid into the plan rather than to the employee, are tax deductible. The maximum contribution per year was set at $44,000 dollars for 2006. It will be adjusted in future years at the inflation rate. This is a sizeable amount of deductible income.
The real disadvantage of the SEP-IRA, especially when compared to a Simple IRA plan, is that it is limited to the contributions of the employer of the employee’s earnings. The employee cannot put any funds into the IRA. The Simple IRA type of pension plan allows the employee to make contributions and the employer is permitted to make matching contributions also. This restriction in the SEP-IRA takes away a bit of control from the employee and limits the options of the employer.
The SEP-IRA is also subject to taxation on earnings. Although all distributions will be taxed at the rate that applies when the distribution is actually made, this is still taxation that could possibly be avoided through a different type of plan. A Roth IRA, for example, does not give a tax break when contributions are made, but does not tax earnings and distributions either. Many people find this more attractive as they anticipate earning large returns on the funds invested in their accounts.
Like other IRA accounts, a SEP-IRA account has the disadvantage of not allowing borrowing against the funds like is possible with a 401K type of plan. Any distribution that is made before the age of 59 and a half is subject to penalties in addition to taxation. There are exceptions to this rule in all IRA accounts including SEP-IRAs. These exceptions are legitimate medical emergencies, the death of the account owner, or education payments for the owner or children. Despite the disadvantages, the SEP-IRA is a feasible option for the small business owner or the self employed worker and should be given serious consideration in the formulation of an overall financial planning process.
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