In the world of retirement savings, it’s easy to get confused because there are so many types of plans, many identified with weird names or containing numbers and letters that correspond to some section of the IRS code book—401(k), 403(b), 457, Traditional IRA, SIMPLE IRA, Roth IRA, Roth 401(k), Solo 401(k), Defined Contribution, Defined Benefit, SARSEP, ESOP and TSP.
But in the midst of this forest of retirement savings vehicles, let us not forget the SEP—Simplified Employee Pension, also referred to as a SEP-IRA, because SEP contributions are made to an Individual Retirement Account (IRA) through a SEP plan. Investment, distribution, and rollover rules for SEP-IRAs are exactly the same as those for a traditional IRA.
Generally, SEP-IRAs are best for self-employed people or small-business owners with few or no employees. Here’s why: If you have employees the IRS considers eligible participants in your plan, you must contribute on their behalf, and those contributions must be an equal percentage of compensation to your own. So, if you want to contribute 15% of your compensation to your account, you have to contribute 15% to the accounts of all your eligible employees.
Eligibility
If you’re a business owner who has established a SEP plan, your eligible employees are those who are:
- 21 years old or older
- You can have less restrictive eligibility requirements if you choose, such as 18 years old or 1 year of service, etc.
- Have worked for you for at least three of the last five years
- Have earned a minimum amount of income as set by the IRS. That amount changes every year. You can find the current amount by googling “SEP contribution limits for (year)”.
For example, if an employee worked for you in 2019, 2020, and 2021 and made or exceeded the minimum earnings requirement, you would need to make a contribution for them for the 2023 plan year.
Employer Contributions
- The employer can contribute up to 25% of an employee’s total compensation or a maximum dollar amount, whichever is less. That dollar amount changes every year. You can find the current amount by googling “SEP contribution limits for (year)”.
- If you’re self-employed, your contributions are generally limited to 20% of your net income.
- Net compensation for self-employed individuals is the net profit from IRS Schedule C reduced by the deductible self-employment tax.
- The eligible compensation limit, indexed for inflation by the IRS can be found by Googling SEP contribution limits for (year).
- Contributions are deductible to the business.
- Contributions are not required every year.
- Contributions must be the same percentage for employers and employees up to the specified limit.
- If an employee is unable or unwilling to set up a SEP-IRA account, the employer can establish an account for that employee, since the employer is required to make contributions for all eligible employees.
- A SEP cannot have a last-day-of-the-year employment requirement. If an employee is otherwise eligible, you must make a SEP contribution for them. This includes eligible employees who die or quit working before the contribution is made.
- You must contribute for each employee eligible to participate in your SEP, even if they are over age 72. That employee must also take minimum distributions, however.
- Employer SEP contributions are not taxable to the employee.
- The employee will pay taxes on any SEP distributions.
Compensation Included in Determining Employer Contributions
- For an individual who is not self-employed, compensation used to determine SEP contributions generally includes: wages, salaries, tips, overtime, bonuses, commissions, vacation and sick pay, fees, and other remuneration from the employer for services performed.
- Compensation does not include severance pay, nontaxable fringe benefits, or worker’s compensation.
- Compensation is limited to a maximum dollar amount that changes annually. You can find the current amount by googling “SEP contribution limits for (year)”.
Employee Contributions
Unlike other retirement plans, employees cannot defer their salary to make contributions to a SEP-IRA. However, if the plan allows, employees can make traditional IRA contributions to the SEP-IRA as well as catch-up contributions for employees 50 or older.
- Contributions to employee accounts must be cash; you cannot contribute property.
- Employees have full control of investment and distribution decisions for their accounts.
Self-Employed Contributions
- If you’re self-employed, there is a special calculation to determine contributions for yourself.
- Special rules apply when figuring the maximum deductible contribution. Those rules are in Publication 560.
Even as a self-employed person you are not allowed to make catch-up contributions to a SEP plan. SEPs are funded by employer contributions only. However, if the SEP plan document allows, you are permitted to make traditional IRA contributions to your SEP-IRA account, which includes catch-up contributions if you are age 50 or older.
Establishing a SEP
There are three basic steps in setting up a SEP, all of which must be satisfied.
- Adopt a formal written agreement by signing one of these documents:
- IRS model SEP using Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement(PDF);
- IRS-approved prototype SEP, offered by banks, insurance companies, and other qualified financial institutions; or
- Individually designed SEP plan document.
- Provide each eligible employee with information about the SEP. If you established the SEP using Form 5305-SEP, the information must include a copy of Form 5305-SEP, its instructions, and the other information listed in Form 5305-SEP instructions. If you used a prototype SEP or individually designed SEP, you must provide similar information.
Set up a SEP-IRA for each eligible employee with a bank, insurance company, or other qualified financial institution. The employee owns and controls the SEP-IRA.
If you’re interested in setting up a SEP plan you’ll find more details here.
Disclaimer
This information is presented for informational purposes only and does not constitute an offer to sell, or the solicitation of an offer to buy any investment products. None of the information herein constitutes an investment recommendation, investment advice, or an investment outlook. The opinions and conclusions contained in this report are those of the individual expressing those opinions. This information is non-tailored, non-specific information presented without regard for individual investment preferences or risk parameters. Some investments are not suitable for all investors, all investments entail risk and there can be no assurance that any investment strategy will be successful. This information is based on sources believed to be reliable and Alhambra is not responsible for errors, inaccuracies, or omissions of information. For more information contact Alhambra Investment Partners at 1-888-777-0970 or email us at [email protected].
