SEP IRAs: Eligibility Requirements
To save money in a SEP, the plan needs to be established by your employer. That employer could be yourself. But if you have any employees who would be eligible under SEP rules (see below), they must all be included.
Who May Establish a SEP Plan?
Any employer – including a sole proprietorship, partnership, corporation, and nonprofit organization – with one or more employees may establish a SEP plan. This includes a self-employed business owner, regardless of whether he or she is the only employee of the business. An individual employee may not establish a SEP plan; instead, individual employees who are eligible to participate in their employer's SEP plan must open individual Traditional IRAs to which their employers will deposit SEP contributions. Generally, a traditional IRA that receives SEP employer contributions is referred to as a SEP IRA and is labeled as such by the financial institution that holds the account (its custodian/trustee).
Why Establish a SEP?
Unlike qualified plans, a SEP plan is easy to administer; and the start-up and maintenance costs for SEP plans are very low compared to qualified plans.
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 a SEP IRA.) Another attractive feature of the SEP plan is that employees generally may make their personal traditional IRA contributions to that same SEP IRA.
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 a SEP plan may affect their ability to deduct traditional IRA contributions. (To learn more, see Traditional IRA Deductibility Limits.)
How Is a SEP Plan Established?
The employer must follow three basic steps to set up a 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, a sole proprietorship that operates on a calendar-year basis has until April 15 (plus extensions) to establish its SEP plan. SEP plans that are established after this deadline cannot receive a 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 is the easiest way because the language is simple, the sections to be completed are few, and there is no special requirement to have the IRS approve the agreement. 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) could 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 that is not eligible to use a Form 5305-SEP may use a prototype SEP or an individually designed SEP document.
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 SEP plan on a fiscal year and allow employees to make salary-deferral contributions. IRA custodians get approval from the IRS for their prototype SEP agreements, after which the plan may be legally established.
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 should 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 document.
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 SEP agreements, the employer might be required to provide additional documentation, such as a summary of plan information.
Step 3: Ensure that a SEP IRA is established for each eligible employee.
Failure to ensure that an eligible employee establishes a 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 $600 (indexed) for the year.
- Has worked for the employer for three out of the five years that precede the year for which the contribution is being made. Any three years in the preceding five years must be considered for determining eligibility, regardless of how short a period the employee worked during a year.
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 would 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 $275,000 may not be considered for the purposes of making a SEP contribution.
SEP IRAs: Contributions