SEP-ing Out Taxes, Getting Credit and Using IRAs

This week, Gail has a few tips on SEP-ing out taxes, getting credit for adopting and using IRAs to pay off student loans.


If I put funds into a SEP, are these funds taxed for Social Security and Medicare in the same manner as 401k plans? Or are they treated as pension plans that are not taxed for Social Security and Medicare?


Dear Paul,

SEP stands for "Simplified Employee Pension." It's a low-cost, low-maintenance retirement plan specifically for companies with 25 or fewer employees.  Contributions to the plan are only made by the employer.  A self-employed person could also have a SEP.

Up until a few years ago, you could also add a feature that would let employees make contributions to their accounts, as well.  These plans are called "SAR-SEPs," shorthand for "Salary Reduction SEP."  However, while already-established SAR-SEP plans can continue, new ones are no longer allowed.

April Caudill is an attorney who specializes in pensions and taxes at The National Underwriter Company. She says if you are covered by a plain "SEP" - with the contributions coming solely from your employer- then this money is not subject to either FICA (Social Security & Medicare taxes) or FUTA (federal unemployment tax).

However, if you are covered by one of the old SAR-SEP plans, your own contributions to your account are subject to these taxes, as are all employee contributions to retirement plans.

Hope this clears things up,

Dear Gail Buckner:

My wife and I have just adopted a beautiful baby girl from Colombia, South America. For the tax year 2001 there is a $5,000 tax credit available and the amount is scheduled to increase to $10,000 in 2002. The tax code states that the credit is taken in the year that the adoption becomes final. My question is what is the definition of final?

We did go through a formal court procedure in Colombia. However we are also going to go through a re-adoption here in New York State. We are wondering if we should push the court date into 2002?

Thanks for your help!!


Dear Tom,

First of all, congratulations on the new addition to your family!  I hope this gets to you in time. Jerry Weinstein, a CPA in Roxbury, Mass., says if you can push the formal U.S. adoption procedure into 2002, you will be able to take advantage of the higher tax credit.

It doesn't matter when the Colombian paperwork was completed. Since this is a U.S. tax credit, it's the U.S. adoption date that determines the year in which you are eligible. In other words, your daughter's adoption becomes "final" when a U.S. court says it does.

You cannot take the full tax credit unless your adoption expenses equal or exceed that amount.  The good news is, according to Weinstein, these would include adoption fees, attorney and court costs (both in Colombia and here), and travel-related items such as airfare, lodging and meals.

A tax credit is much more valuable than a tax deduction because, instead of reducing the income you owe tax on, it is a dollar-for-dollar reduction of your tax bill itself. Clearly, by doubling the tax credit in 2002, the federal government is encouraging people to undertake adoptions.

Best wishes to you and your family,

Can a person withdraw money from their Roth IRA to pay off student loans, or  must the money be used up front only for education without penalty?

Thank you,

Dear Chris,

First of all, you can withdraw your $2,000 annual contributions from a Roth IRA at any time and without penalty. You don't have to explain a thing. It's your money and you can have it back to spend however you wish. However, I strongly suggest you have a tax professional fill out the paperwork for you. Years from now, you will appreciate having a record of this transaction, especially if you are audited.

It's just when you start dipping into the gains those IRA contributions have earned that you can become subject to the 10% penalty and ordinary income tax. The only way gains/profits can escape both income tax and the penalty is if your Roth IRA has been open at least 5 years and you are at least 59 1/2 years old. 

Since Roths weren't available until 1998, no one in America could possibly qualify for this until 2003, at the earliest. (The first possible 5-year period runs from Jan.1, 1998 though Dec. 31, 2002 so the money could not be withdrawn until the following year.)

On the other hand, if your Roth IRA is funded with "converted" money from a traditional IRA, then different rules apply. In order to convert your traditional IRA to one of the Roth variety, you had to pay all of the income tax due on that money. Since you can't be taxed twice on this, there would be no income tax due if converted dollars are withdrawn. If
you withdraw your conversion contributions within 5 years, however, you would be hit with the 10% penalty on the contributions (as well as any earnings) withdrawn, unless one of the exceptions to the penalty applied.

Complicating things further, you can only use IRA money to pay for higher education costs which meet the definition of "qualified expenses." Student loan repayments do not appear to qualify. The tax code makes it very clear that IRA withdrawals to pay for education expenses avoid penalties only if the expenses were incurred in the same year as the withdrawal.  Assuming your loans apply to college-related expenses from a year or more ago, this rules out the possibility of a penalty-free withdrawal from any type of IRA to pay off your student loans.

I hate to say it, but if you absolutely cannot stand paying your student loans off over time, then the easiest and least costly thing to do is to only withdraw your regular (non-conversion) contributions to your Roth. That way you avoid both income tax and penalties.

Do me a favor: think long and hard before you take a withdrawal from the best retirement deal in America - the Roth IRA.

P.S. Just a reminder: the maximum annual contribution to Roth and traditional IRAs jumps to $3,000 in 2002.

If you have a question for Gail Buckner and the Your $ Matters column, send them to along with your name and phone number.

The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.