A SEP IRA Is An Easy Retirement Plan for Small Business Owners

By March 21, 2016 Blog No Comments
SEP IRA

What is a SEP IRA?

With many individual retirement account options, it’s hard to choose the vehicle that will help you maximize your retirement savings. One option is the Simplified Employee Pension plan, also known as the SEP IRA.

What is an IRA?

An individual retirement arrangement is an account that allows holders to make investments that will provide them with tax advantages as they establish financial security for their retirement years. There are many types of IRAs, including both tax-deferred and post-tax savings plans. Traditional and Roth IRA plans are the primary choices for most individuals. Other options include the SIMPLE and SEP IRA. With more than 25 million IRAs in the United States holding trillions of dollars, individuals and employers looking to create a retirement plan should understand every type of IRA.

What is the SEP IRA?

SEP IRA stands for the Simplified Employee Pension Individual Retirement Arrangement. This IRA allows employers to contribute to an employee’s traditional IRA. In this plan, employers are the only contributors to individual retirement accounts for themselves and their employees. Employees cannot choose to contribute additional dollars.

Self-employed business owners, small business owners, or individuals earning freelance income often choose the SEP IRA, as all contributions are made directly by the employer, and the business can employ even just one employee.

How does the SEP IRA differ from traditional retirement plans?

Unlike many conventional retirement plans, the SEP IRA does not require the same level of start-up, operating, and maintenance costs. Also, SEP IRA holders may be eligible for an annual tax credit for the first three years of the plan.

Contributing to an SEP IRA

Contributions to SEP IRAs by the employer are not required each year. However, if an employer chooses to participate, he or she must not only contribute to his or her individual account but must also to the accounts of every eligible employee who performed work for the company in that year. Contributions must also be equal, meaning that the employer has to contribute the same percentage to owners, key employees, and non-key employees.

An eligible employee is someone who is at least 21 years old and employed for at least three of the last five years. Additionally, the employee must have received at least the IRS-required minimum compensation from the employer during the year (in 2016, this amount is $600). As these are the only requirements, contributions are not solely limited to full-time employees. All part-time employees, seasonal employees, and employees who have passed away or left the place of employment in that year must also receive contributions that year, provided they met the eligibility requirements.

Employers are also allowed to make less restrictive guidelines, such as those regarding age, length of employment or compensation, but are not permitted to make more restrictive eligibility requirements.

There is no requirement to cover employees who are members of affiliated service groups, controlled groups or corporations, or trades or businesses under common control, nonresident alien employees who did not earn an income, or employees who earned less than the IRS-determined minimum compensation in that year.

The SEP allows for contributions of the lesser of either up to 25 percent of each employee’s pay or a maximum amount as determined by the IRS ($53,000 in 2016). The limits apply to total contributions to the SEP IRA, as well as other defined contribution plans.

Getting Started and Maintaining the SEP IRA

Opening the SEP IRA is an attractive option for most individuals, as there are very few steps or start-up costs. The first step is to choose a financial institution, which will become a trustee of the plan, both receiving and investing the contributions and providing each participant with an individual note of employer contributions.

Second, complete and sign the plan documents to establish the SEP IRA. Third, give each employee a copy, along with the eligibility requirements and specific information as outlined by the United States Department of Labor.

Participants may not take loans from their SEP IRA, but may make withdrawals that can be rolled over tax-free to another SEP or Traditional IRA or qualified retirement plan, or withdrawn, but subjected to income tax for the year an employee received a distribution. Each employee is 100 percent vested in his or her individual SEP IRA.

Participants are required to withdraw a set minimum from their accounts by April 1 of the year after they turn 70 ½, and the trustee – the financial institution – will notify participants by Jan. 31 of that year. Funds withdrawn before that age are subject to a set tax amount, usually 10 percent.

There are typically no filing requirements placed on employers, but the United States IRS, Department of Labor, and the employer’s tax advisor can provide guidance not only on any filing requirements but also on finding and correcting SEP IRA errors.

About Woven Capital

Aaron Hatch is a Certified Financial Planner and co-founder of Woven Capital, a fee-only financial planning and investment management firm that specializes in helping people balance life, work, and community. Aaron has been quoted in various publications, including The Chicago Tribune, US News and World Report, and the Huffington Post among others. Aaron can be reached at aaron@wovencapital.net