SEP IRAs: Eligibility Requirements
By Denise Appleby
Who May Establish an SEP?
Any employer - including a sole proprietorship, partnership, corporation, and nonprofit organization - with one or more employees may establish an SEP plan. This includes a self-employed business owner, regardless of whether he or she is also the only employee of the business. Individual employees may not establish an SEP plan; instead, individual employees who are eligible to participate in the SEP plan must establish their individual Traditional IRAs to which the employer will deposit SEP contributions. Generally, a Traditional IRA that receives SEP-employer contributions is referred to as an SEP IRA and is labeled as such by the financial institution.
Why Establish an SEP?
Unlike qualified plans, an SEP plan is easy to administer. The start-up and maintenance costs for SEPs are very low compared to qualified plans, and since contributions are discretionary, the employer decides every year if it wants to fund the SEP for that year. (For more insight, read Business Owners: How To Set Up An SEP IRA.)
Another attractive feature of the SEP plan is that employees may use the same account for their SEP contributions as for their regular Traditional IRA contributions. The limits for the SEP employer contributions and the individual's Traditional IRA contributions are different and do not affect each other. However, an employee's participation in the SEP may affect his or her ability to deduct the Traditional IRA contributions. (To learn more, see Traditional IRA Deductibility Limits.)
How Is an SEP Established?
The employer must follow three basic steps to set up an SEP:
Step 1: Execute a formal written agreement to provide benefits to all eligible employees
This agreement must be completed and signed by the due date of the employer's tax return (including extensions). For instance, an employer who operates on a calendar-year basis has until April 15 (plus extensions) to establish the SEP for the business. SEPs that are established after this deadline cannot receive an SEP contribution for the previous year.
The formal written agreement may be either the IRS model Form 5305-SEP, a prototype SEP designed by a financial institution or the employer's individually designed SEP. Using the IRS model Form 5305-SEP, however, is the easiest way because the language is simple, and the sections to be completed are few. Note, however, that there are certain instances in which an employer may not use a Form 5305-SEP:
- The employer currently maintains any other qualified retirement plan, such as a profit-sharing plan. An employer who maintains another qualified plan must use another type of SEP document.
- The employer has eligible employees for whom SEP IRAs have not been established.
- The employer uses the services of leased employees.
- The employer is a member of a group of businesses that are under common control, and the SEP is not meant to cover all the eligible employees of all the businesses. Certain exceptions apply.
- The employer wants employees to assist with the cost of funding the SEP through salary-deferral contributions. Note: salary-deferral SEPs (SARSEPs) may not be established after December 31, 1996; however, SARSEPs in existence from that time are grandfathered.
- The employer wants to maintain the SEP plan on a fiscal year.
An employer who is not eligible to use a Form 5305-SEP may use a prototype SEP or an individually designed SEP.
A prototype SEP is designed by a financial institution and includes special features generally not included in a 5305-SEP. For instance, a prototype SEP may allow the employer to maintain the plan on a fiscal year and allow employees to make salary-deferral contributions. The IRS must provide approval for the prototype SEP, and any employer who wants to establish an SEP plan can use a prototype SEP.
An individually designed SEP is customized to suit the specific needs of an employer. Like the prototype SEP, it can be drafted to include special features that may not be a part of the 5305-SEP. The employer must obtain IRS approval for the individually designed SEP, and generally, only the employer for which the individually designed SEP was prepared may use that particular SEP plan.
Step 2: Provide each eligible employee with information about the SEP
This includes information regarding the SEP eligibility requirement and the general rules and guidelines of the SEP plan. For 5305-SEPs, providing eligible employees with a copy of the SEP agreement is sufficient to meet this notification requirement. For other SEPs, the employer may be required to provide additional documentation such as a summary of the plan description.
Step 3: Ensure that an SEP IRA is established for each eligible employee
Failure to ensure that an eligible employee establishes an SEP IRA and receives SEP contributions could cause the IRS to disqualify the SEP plan.
Generally, any employee who meets the following requirements must be allowed to participate in the SEP:
- Reaches at least age 21.
- Earns at least $550 (indexed) for the year.
- Has worked for the employer for three out of the five years prior to the year for which the contribution is being made. Any three years in the past five years must be considered for determining eligibility, regardless of how short a period the employee worked during the year.
Example: SEP Eligibility Based on Length of Employment
ABC Corporation established an SEP plan for the business, and the eligibility requirements are as stated above. John performed services for ABC Corporation during 2009, 2010, 2011, 2012 and 2013. During 2010 and 2011, John worked one month in each year. For 2012 and 2013 he worked the entire year. ABC decided to make a 15% contribution for all eligible employees for the 2013 plan year. If John meets the other eligibility requirements, ABC must make a contribution to John\'s SEP IRA because John worked three of the five years preceding 2013.
Employers should take care to ensure that the eligibility requirements they establish do not exclude themselves from participating in the plan. An employer who is 18 years old will not want to elect an eligibility requirement of 21 years as he or she will be excluded along with other employees who are under age 21. Employers can always choose eligibility requirements that are less restrictive than the ones stated above.
Employees whose retirement and compensation package are provided under a collective bargaining agreement (unionized employees) and nonresident aliens may be excluded from participating in the SEP plan.
For common-law employees, compensation is based on W-2 wages. Compensation for sole proprietors is based on Schedule C income and, for partners in a partnership, Schedule K-1 income. An employee's compensation in excess of $255,000 may not be considered for the purposes of making an SEP contribution.
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