A simplified employee pension (SEP) is a retirement plan that an employer or self-employed individuals can establish. The employer is allowed a tax deduction for contributions made to the SEP plan and makes contributions to each eligible employee's SEP IRA on a discretionary basis.
Contributions to simplified employee pension IRAs are immediately 100 percent vested, and the IRA owner directs the investments.
An eligible employee (including the business owner) who participates in his or her employer's SEP plan must establish a traditional IRA to which the employer will deposit SEP contributions. Some financial institutions require the traditional IRA to be labeled as a SEP IRA before they will allow the account to receive SEP contributions. Others will allow SEP contributions to be deposited to a traditional IRA regardless of whether the IRA is labeled as a SEP IRA.
Many small organizations favor SEP plans because of eligibility requirements for contributors, including minimum age of 21, at least three years of employment and a $600 compensation minimum. In addition, an SEP IRA allows employers to skip contributions during years when business is down.
Contributions made by employers cannot exceed the lesser of 25 percent of an employee's compensation, or $55,000 maximum (for 2018). As with the traditional IRA, withdrawals from SEP IRAs in retirement are taxed as ordinary income. When a business is a sole proprietorship, the employee/owner both pays themselves wages and may also make a SEP contribution, which is limited to 25 percent of wages (or profits) minus the SEP contribution. For a particular contribution rate CR, the reduced rate is CR/(1+CR); for a 25 percent contribution rate, this yields a 20 percent reduced rate, as in the above.
Because the funding vehicle for a SEP plan is a traditional IRA, SEP contributions, once deposited, become traditional IRA assets and are subject to many of the traditional IRA rules, including the following:
SEP contributions and earnings are held in SEP-IRAs and can be withdrawn at any time, subject to the general limitations imposed on Traditional IRAs. A withdrawal is taxable in the year received. If a participant makes a withdrawal before age 59½, generally a 10 percent additional tax applies. SEP contributions and earnings may be rolled over tax-free to other Individual retirement account and retirement plans. SEP contributions and earnings must eventually be distributed following the IRA required IRA required minimum distributions.