What is a SEP IRA?
A SEP IRA stands for a simplified employee pension individual retirement arrangement. It is a type of employer-sponsored retirement plan that can be set up by self-employed people or by businesses that have few employees.
A SEP allows business owners to set up a simple retirement arrangement through which they can contribute to their own retirement as well as that of their employees on a tax-free basis. The contributions are made by the business owner to individual retirement accounts that are established for each employee. The business owner can then claim an IRA tax deduction for the contributions that are made. SEP IRAs are traditional IRAs but have higher contribution limits.
Who qualifies under the SEP IRA rules? What are the SEP IRA limits?
These IRAs were designed to meet the needs of small businesses. While any business can establish a SEP, it does not make sense for companies that have more than five employees. Under the SEP IRA rules, business owners must contribute an equal percentage to each eligible employee’s IRA account as they do to their own. The mandatory nature of the contributions can make these plans untenable when there are more employees.
All eligible employees must receive SEP IRA accounts, and the contributions are made by the employer. Employers can contribute up to a maximum of 25% of the annual income or $56,000, whichever is less. SEP-IRAs may benefit self-employed people because of the higher annual maximum contributions and the ability of the contributions to grow tax-deferred.
Statistics and market trends for SEP IRAs
In a survey of small business owners that was conducted by Manta, 34 percent reported that they did not have retirement plans. Of the business owners who did have retirement plans, only ten percent reported that they had SEP-IRAs.
Among households reporting that they owned IRAs in an ICI report, 6 percent reported that they had employer-sponsored IRAs such as SEPs, SAR-SEPs, and SIMPLE IRAs. SEP-IRAs and SAR-SEP IRAs have grown in popularity, reaching more than $425 billion in assets.
SEP or simplified employee pension
A simplified employee pension plan is a type of employer-sponsored IRA retirement plan that small business owners and self-employed people can establish. This type of plan costs less to administer than a 401(k) plan. Employers that establish SEP-IRAs are not required to contribute every year. Any year in which they do contribute, they must contribute an equal percentage to all of their employees’ SEP IRA accounts.
The SEP IRA limits allow employers to contribute up to 25 percent of each employee’s compensation or a maximum of $56,000, whichever amount is less. The contribution limits count toward your combined traditional and Roth IRA contribution limit of $6,000 per year if you are under age 50 or $7,000 per year if you are older than 50. If you establish one at your business, you must contribute to all of your eligible employees’ accounts at the same percentage during any year that you fund your own SEP.
Under the SEP IRA rules, eligible employees include the following:
- Age 21 or older
- Have earned a minimum of $600 during the year
- Have worked for the employer for three out of the five years prior to the year in which the contributions are made
You are not permitted to take loans from your SEP plan. However, you are able to withdraw funds at any time which are taxable in the year that they are received.
Under the IRA distribution rules, if you take an early withdrawal from your SEP IRA that occurs prior to when you reach age 59 ½, you will be assessed a 10 percent early withdrawal penalty in addition to the income tax. There are some types of penalty exceptions, including the following:
- Withdrawals due to the death of the SEP owner
- Withdrawals due to disability
- Payment for certain qualified higher educational expenses
- Series of substantially equal periodic payments
- Up to $10,000 to purchase a first home
- Funds to pay IRS tax levies
- Certain unreimbursed medical expenses
- Health insurance premiums during unemployment
- Certain situations concerning military active duty
Each of these exceptions has specific rules. If you plan to take a withdrawal under an exception, you will want to make certain that your situation qualifies.
Under the SEP IRA rules, you must begin taking required minimum distributions beginning on April 1 of the year after you turn age 70 ½. You must then continue taking RMDs by Dec. 31 of each successive year. If you fail to take your RMDs, the IRS will assess a penalty of 50 percent of the amount that should have been withdrawn.
Is a SEP IRA right for me as an employer?
While this type of IRA can be beneficial, it is not the right option for all business owners. Because of the mandatory contributions, a SEP plan is best for people who are self-employed or who are small business owners with only a few employees.
A benefit is that it is inexpensive to set up and operate. The administrative costs of a simplified employee pension are much lower than they are for a 401(k) plan. The contributions that you make are tax-deductible and flexible. Each year, you can choose whether or not you want to contribute. However, if you do choose to contribute to your own SEP-IRA, you must contribute an equal percentage to all of the accounts of your eligible employees.
Another benefit is the high SEP contribution limit. You are able to contribute up to 25% of your income or $56,000, whichever is less. This can be very helpful to self-employed people who are not covered under a 401(k) plan at work. Your SEP IRA can also combine with a traditional IRA or Roth IRA. SEP contributions do count towards the annual contribution limits for Roth and traditional IRAs.
Opening a SEP IRA
You can set up a simplified employee pension through a bank, a mutual fund company, or a brokerage firm. Once you have chosen the institution that you want to handle your accounts, you can open SEP IRAs for yourself and each of your eligible employees. After you send the contributions, the institution will then manage the funds on your behalf.
When you are searching for an institution to manage your SEP plan, look for one that charges low or no commissions or management fees. If you choose a brokerage or other institution that charges high fees, the fees will eat into your earnings substantially over time.
To set up a SEP plan, the IRS requires you to complete the following steps:
- Draft a written agreement that you will provide SEP IRAs to all of your eligible employees
- Provide information about the SEP plan to all of your employees
- Set up an IRA account for each of your eligible employees
The written agreement must include the employer’s name, the participation requirements for the employees, signatures, and a defined allocation. After you have executed the written agreement, you need to provide detailed information about the pension plan to each employee. Finally, set up a SEP IRA account for each of your eligible employees.
The deadline for contributing funds to your pension plan is up until your tax-filing deadline in the middle of April. If you file an extension, your deadline for making contributions and claiming them as an IRA tax deduction for the prior tax year will be in October.
Operating a SEP
For the SEP IRA limits that you make as an employer, you must follow your written agreement. Your SEP IRA limits should be based on the first $280,000 and provide an equal percentage for every employee. The SEP IRA limits are capped each year at the smaller of $56,000 or 25 percent of each employee’s compensation. You pay the funds directly to the employees’ SEP accounts.
If you are self-employed and do not have any employees, you calculate your SEP IRA limits in a different way. You take your net earnings minus your deductions. To complete this calculation, subtract one-half of your self-employment tax and the contributions to your SEP.
You are not required to participate in your plan every year. However, in years that you do, you must contribute an equal percentage to each participant who performed services during the year. This includes employees who died or who were terminated before the contributions were made.
Your contributions can be counted for the prior tax year up to the federal income tax filing deadline, including extensions. Employers are able to deduct contributions, and employees can exclude them from their gross income.
SEP contributions can be invested in the following types of investments:
- Mutual funds
- Money market funds
- Savings accounts
- Other similar investments
Ownership of a SEP
After you open the accounts for each of your employees, they will have complete control of them. The contributions that you make are theirs, and they can place them into the investments of their choice. Your contributions also stay with the employees and leave with them, regardless of any vesting.
If you have a SEP IRA from your former employer, you are allowed to roll the funds over into different types of IRA accounts. You can roll the money over to a Roth IRA or a traditional IRA. You can also roll the funds over to a SIMPLE IRA after two years.
The contributions in your account and the earnings can be rolled over tax-free to other IRAs and retirement plans. However, if you are rolling the money over to a Roth IRA, you will be taxed on the amount that is rolled over since the contributions were made on a pre-tax basis.
Terminating a SEP
If you are an employer and want to terminate your SEP, you are not required to notify the IRS. You will need to inform the financial institution that manages your plan that you are terminating it. It is a good idea to also inform your employees. A SEP plan can be terminated at any time.
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