August 31, 2010

Simplified Employee Pension Plan (SEP IRA)

Since I have already written the small business retirement plans quick list it is now time to break down each retirement plan that I listed before in more depth. The first that we will cover is called the Simplified Employee Pension Plan (SEP). Most of the information involves using it as an employer, but I have included the exceptions and differences in rules if you plan to use the SEP IRA as self-employed persons, partnerships, sole proprietors, independent contractors, and owner-employees of an unincorporated trade or business; however, it may be set up by any type of business.

What is a SEP?

The Simplified Employee Pension Plan, or SEP IRA as it is more commonly known, is one of the many options for funding a retirement account for your employees of any business, or just for yourself if you are self-employed. The SEP IRA is very easy to understand and the administration costs are very low, unlike other plans such as the most widely known retirement plan , the 401k. The costs are almost non-existent if you are self-employed and have no employees. Contributions are made directly to an Individual Retirement Account or Annuity (IRA) set up for each employee by the employer. No employee contributions are allowed.

Standard withdrawal rules for qualified retirement plans apply. Withdrawals before the age of 59.5 are subject to penalty, and withdrawals are taxable upon taking the money out. Money in the plan is able to grow tax-deferred while it is in the plan like any other IRA.

Setting Up a SEP IRA

The process of setting up a SEP IRA is a short and painless process. An employer must set up a SEP IRA agreement and have eligible employees. There are three basic steps according to the IRS that must be satisfied in order to create a Simplified Employee Pension Plan:

1. A formal written agreement must be executed. This written agreement may be satisfied by adopting an Internal Revenue Service (IRS) model SEP using Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement. A prototype SEP that was approved by the IRS may also be used. Approved prototype SEPs are offered by banks, insurance companies, and other qualified financial institutions. Finally, an individually designed SEP may be adopted.

2. Each eligible employee must be given certain information about the SEP. If the SEP was established using the Form 5305-SEP, the information must include a copy of the Form 5305-SEP, its instructions, and the other information listed in the Form 5305-SEP instructions. If a prototype SEP or individually designed SEP was used, similar information must be provided.

3. A SEP-IRA must be set up for each eligible employee. SEP-IRAs can be set up with banks, insurance companies, or other qualified financial institutions. The SEP-IRA is owned and controlled by the employee and the employer sends the SEP contributions to the financial institution where the SEP-IRA is maintained.

Employee Eligibility for a SEP IRA

To be eligible for a SEP IRA as an employee the following conditions must be met:

1. The employee is at least 21 years of age.

2. has worked for the employer in at least 3 of the last 5 years

3. has received at least $450 (subject to annual cost-of-living adjustments) in compensation from the employer for the year ($500 for 2007).

Employees may be excluded from the plan under only 2 conditions: (a) employees covered by a union agreement whose retirement benefits were bargained for in good faith by the employees’ union and the employer; and (b) nonresident alien employees who have no U.S. source compensation from the employer may be excluded.

SEP IRA Contribution Limits

Annual contributions an employer can make for an employee in a given year may not exceed the lesser of the following:

1. 25% of an employee’s income

2. $44,000 for 2006 ($45,000 for 2007 and subject to annual cost-of-living adjustments for later years).

The limits apply in the aggregate to contributions an employer makes for its employees to all defined contribution plans, which includes SEPs. Only up to $220,000 in 2006 ($225,000 in 2007 and subject to annual cost-of-living adjustments for later years) of an employee’s compensation may be considered. Contributions must be made in cash. Property cannot be contributed.

Regardless of the limits, an employer can choose any percentage, or total below the amount stated as the maximum allowable by the IRS. Employers are NOT required to contribute to the employees’ SEP IRAs every year. It is at the full discretion of the employer, but when contributions are made, they must be made into the SEP IRA accounts of every eligible employee.

Deducting SEP IRA contributions

Of course when contributing to an employee retirement plan an employer has the right to deduct some, or all of that contribution from the business’s taxes. Let’s look at exactly how much you can deduct for your SEP IRA contributions.

The most that may be deducted on the business’s tax return for contributions to its employees’ SEP-IRAs is the lesser of its contributions or 25% of compensation. (Compensation considered for each employee is limited to $220,000 in 2006, $225,000 for 2007 and subject to annual cost-of-living adjustments for later years.)

If the employee is self-employed and contributes to his or her own SEP-IRA, a special computation to figure out the maximum deduction for these contributions must be made. When figuring the deduction for contributions made to a self-employed individual’s SEP-IRA, compensation is net earnings from self-employment which takes into account the following deductions:

1. the deduction for one-half of the individual’s self-employment tax, and

2. the deduction for contributions to the individual’s own SEP-IRA.

See Publication 560 for details on determining the deduction.

SEP IRA for Self-Employed Individual

Self-employed individuals are subject to the same contribution limits as they would be for the sontributions they made for employees. 25%, or $45,000, whichever is less. Although the plan is very easy to use, there may be better options than using a SEP IRA if you have a significantly higher income and would like to contribute more to a retirement plan. Especially if you are married. In a leter post I will discuss the option of using the Solo 401K plan, or the Individual 401k plan as an option for sole proprietorships, partnerships, LLCs and corporations (including both subchapter S and C corporations) who have no employees.

SEP IRA Pros and Cons

Pros:

Contributions do not have to be made every year, which is very appealing. Contributions are not set at any level, and do not have to be the same every year. Very easy and cheap to set up and administer. Immediate vesting for the employee (which is an employer con). Employees must have worked for you for 3 out of the last 5 years to be eligible for contributions. If you have a high employee turnover rate, or you have a few employees that are important to your business this can be a plan that sort of disqualifies short-term employees, but at the same time rewards your loyal ones.

Cons:

Must cover all qualifying employees. Employees cannot contribute. Vesting is immediate. This means that once you put the money in it is theirs.

Filed under Financial Planning, Investment vehicles and strategies, Retirement Planning