SEP IRA

Can your small business benefit from a SEP IRA plan?

A Simplified Employee Pension IRA, or SEP IRA, is an easy, low-cost way to offer retirement benefits to employees for a small business. Any sole proprietor, partnership, corporation, or nonprofit can set up a SEP IRA. However, it’s best suited to sole proprietors and small businesses with few employees.

What Is a SEP IRA?

Even though the “P” in SEP stands for pension, a SEP IRA is a defined contribution retirement plan, much like a 401k. The one difference – only the employer makes tax-deductible contributions on behalf of eligible employees with a SEP IRA. Employees are not permitted to defer their income.

These contributions grow tax-deferred, while withdrawals are taxed as regular income, similar to other retirement plans. If you’re under age 59.5, withdrawals are subject to a 10% penalty unless you qualify for one of the exceptions.

The other difference is that SEPs provide business owners contribution flexibility. The owner can make multiple contributions a year or make one significant contribution at the end of the year or even as late as the tax filing date. 

Another point of flexibility is that SEP IRA contributions are optional. The company is not required to make annual contributions. So, deciding to contribute, or how much, can change each year. When business is down, contributions can be reduced or eliminated. 

SEP IRA contribution limits

In a SEP IRA, annual contribution limits cannot exceed the lesser of:

  • 25% of compensation for each eligible employee

or

  • $61,000 in 2022.

The maximum compensation used to calculate the 25% limit is limited to $305,000 in 2022. There are no catch-up contributions at age 50+ for SEP IRAs. Let’s not forget to mention that business owners also get tax deductions for their contributions. Also, if you have more than one defined contribution plan for employees, in that case, the contribution limits apply to employer contributions made to all accounts.

Self-Employed Calculation

The self-employed are both the employer and employee, and the same contribution limits apply. However, the maximum deductible contribution is calculated from net profits.

NetProfits – 1/2 of the self-employment tax = SEP contribution

SEP IRA Requirements

As mentioned previously, SEP IRAs are best for self-employed people or small-business owners with few or no employees due to the following requirements. 

  1. If you have eligible employees, you must contribute on their behalf. Eligible participants are employees, 21 or older, who have worked for three of the past five years, and earned at least $600 in the past year. 
  2. The contribution percentage of compensation must be equal for everyone. If the owner wants to contribute 20%, they must also contribute 20% for every eligible employee.
  3. Required contributions include those employees that only worked for part of the year. An employee that left the company for any reason must receive a SEP IRA contribution as long as they were eligible and performed work during the year.

How to set up a SEP IRA

It’s easy to open and maintain a SEP IRA Plan for your employees. A SEP IRA can be created any time before a company’s tax filing deadline and make contributions for that tax year. For instance, if an S-Corporation’s tax deadline is March 15, 2022, they may establish a SEP anytime before that date and make 2021 contributions. The three steps for setting it up:

  1. Create a written agreement. This is done with IRS Form 5305-SEP.
  2. Provide eligible employees information about the SEP IRA. This information is provided at initial setup, when employees become eligible, and annually. Giving them the Form 5305-SEP qualifies.
  3. Set up a SEP IRA for each eligible employee with the account provider. You have to choose a custodian. 

What Else Do I Need to Know About SEP IRAs?

There are several other facts of a SEP IRA to be aware of. 

  •  No Roth SEP: No after-tax Roth contributions are allowed in a SEP. 
  • Required Minimum Distributions (RMDs): Like traditional IRAs and 401(k)s, SEP IRAs have RMDs beginning at age 72.
  • Employees own and control their own accounts.
  • Some employers allow employees to make traditional IRA contributions to their SEP IRA account. If they qualify, they can contribute up to $6,000 ($7,000 if you are 50+). This contribution is not in addition to any other traditional or Roth IRA contribution. It is entirely separate from any employer contributions. It can be combined with a traditional IRA or a Roth IRA.
  • Investments: The selection typically includes stocks, bonds, and mutual funds. 

Why or why not a SEP IRA

Whether or not a SEP IRA is appropriate can be viewed from two different perspectives, the owner and the employee.

It’s been mentioned a few times that a SEP IRA is most appropriate for small businesses with few employees because the employer contribution has to be the same for all participants. This rule is sometimes problematic for the company owners that want to ramp up retirement savings for themselves. They have to ramp up contributions for everyone. That, of course, isn’t a problem when you are both the employer and the only employee.

Since it is only employer contributions, the SEP is a somewhat limiting retirement plan from the employee’s perspective. The employee is left to the generosity of the employer. Maybe the employee wants to save more. Yes, the company may allow the previously mentioned annual IRA contribution. Still, the employee may not even qualify to make an IRA contribution or may want to contribute more.

If your small business is more financially secure or has more employees, consider the other options. Check out our SIMPLE IRA or Solo 401k blog posts to learn to see if they would be a better fit for your situation. 

The Bottom Line

The SEP IRA is a cost-effective, easy way to provide retirement savings for businesses with few employees. However, it is only appropriate for a particular type of small business. Understanding the benefits of a SEP IRA, the requirements, and how that affects the owners’ situation is critical.

Are you unsure which type of small business plan is right for you? Don’t hesitate to contact us to help you analyze the most beneficial retirement savings and tax-efficient option for your business.

 

company-icon
SUBSCRIBE TO RECEIVE OUR BLOG POSTS AND NEWSLETTER DIRECTLY TO YOUR INBOX