A simplified employee pension (SEP) is a cost-effective means for an employer to provide a retirement plan for its employees. This plan allows an employer to make deductible contributions for employees. However, this plan must adhere to provisions contained in a plan document. One big advantage of establishing a SEP IRA plan is that it may be funded up to the due date of the employer's tax return plus extensions for the previous calendar year.
Contributions to a SEP IRA are fully funded by the employer, unlike most IRAs or retirement plans. However, employers have flexibility from year to year on whether they want to fund the plan.
As of 2016, employers are limited to contribute the lesser of:
1) 25% of eligible compensation per employee (up to a cap of $265,000); or
So, for example, if an employee makes $400,000, the maximum contribution would be $53,000 (not $100,000). It is important to know that once a contribution is made to an employee's account, it is 100% vested immediately.
These limits also apply to all contributions made to all aggregate defined contribution plans during the year. If a participant has contributed to another plan during the same calendar year, a maximum total contribution of $53,000 between both plans would apply.
Employer contribution percentages must be equal among all eligible employees. SEP IRAs cannot discriminate to favor an employer’s or officer’s particular account. So if the employer wants to contribute 10% to his personal account, he must also contribute 10% to all eligible employees.
For self-employed companies, calculating SEP IRA contributions is more complicated. The salary of the account holder is often calculated after the contribution is made. Not including limits, the calculation is 18.587045% (approximately 18.6%) of net profit. To be sure, contact a tax professional to assist in calculating the exact allowable amount based on the self-employed income for the year.
SEP IRAs follow the same distribution rules as a traditional individual retirement account (IRA). The 10% Internal Revenue Service (IRS) early withdrawal penalty would apply to any distributions made before the account owner reaches age 59 1/2. There are ways to circumvent the early withdrawal penalties, which are listed on the IRS website.
Any withdrawals from a SEP IRA would also be taxable as ordinary income in the year when it is withdrawn. Like traditional IRAs, once an account holder turns 70 1/2, he must begin taking required minimum distributions. To make things more convenient, SEP IRAs are eligible to roll over directly into a traditional IRA without penalty.
Companies that consist of a single employee or are closely held are ideal candidates for SEP IRAs. These plans are low-cost and easy to operate, making them convenient for most business owners. SEP IRAs also reduce employer risk by shifting the investment decision-making to the employees. Any business entity, such as a sole proprietorship, a partnership, S corporation, C corporation, nonprofit, government entity or limited liability company may establish a SEP IRA.
SEP IRAs have strict eligibility rules for employees. Employees under age 21 are not covered. Those who have not worked or performed any service during any part of three of the prior five years may also be excluded. Those employees that are non-resident aliens with no U.S. source of earned income are excluded, as well as those covered by a collective bargaining agreement. Any employee who earned less than $600 over the course of the year is also ineligible for the SEP IRA.
Setting up a SEP plan requires the employer to complete a SEP adoption agreement, which outlines the provisions of the plan. Most employers use the IRS Form 5305-SEP; however, the 5305-SEP has the following restrictions: no integration with Social Security, no maintenance with another qualified plan and establishment must take place the same calendar year.
When the SEP plan is established, the employer is required to give a copy of the SEP adoption agreement to all eligible employees. From an administrative view, there is no annual IRS reporting. The only requirements are to complete IRS Form 5498, which is generally provided by the custodian of the SEP IRA. The other requirement is to inform eligible employees the amount of the company contribution each year.