This article was last updated on January 15
[Updated for 2019 and 2020 limits] A year or so after starting my small business and completing my first annual tax return that showed a slight profit, my accountant advised that I start looking into a retirement account/plan for my business in order to lower my overall tax bill and also effectively set aside some of my business profits towards retirement. After doing my research I found that if you’re a one person employee/owner business or a small employer with only a handful of employees, a SEP IRA is the best option because it is relatively easy to setup and administer. Further, I am able to have both a SEP IRA and 401K plan that I get from my day-job without any adverse tax impacts. Here are some more details and rules around SEP IRA plans.
What is a Simplified Employee Pension (SEP) or Retirement plan?
A SEP is a popular and widely used retirement plan management approach because it provides self employed owners or small business owners with a few staff a simplified method to make contributions toward their employees’ retirement and, if self-employed, their own retirement. Contributions are made directly to an Individual Retirement Account or Annuity set up for each employee (a SEP-IRA). Various brokers provide IRA accounts for small business’. Contributions can be made to a SEP IRA with self employment income even if you participate in a 401k, 403b, or 457 or other retirement plan.
Who is Eligible?
Any employer can establish a SEP and is independent of company/incorporate type. However the tax advantages and administrative costs can vary based on incorporation rules. An eligible employee for a SEP IRA is one who meets the following requirements:
* attained age 21;
* has worked for the employer in at least 3 of the last 5 years;
* has received the annual minimum compensation amount (see table below) over the last two years from the employer for each year
Like a traditional IRA plan, contributions to a SEP IRA are generally 100% tax deductible and investment earnings in a SEP IRA grow taxed deferred. Withdrawals after age 59 1/2 are taxed as ordinary income. Withdrawals prior to age 59 1/2 may incur a 10% IRS penalty as well as income taxes.
While traditional and Roth IRAs are accounts most of us set up on our own, outside our workplaces, SEP IRAs are tied to our jobs. A SEP is set up by an employer (including a self-employed person) and permits the employer (not the employee) to make contributions to the SEP IRA accounts of eligible employees. The employer gets a tax deduction for contributions made, and the employee is not taxed on those contributions, though their eventual withdrawals will be taxed at their income tax rate. Of course, a self-employed person is both employer and employee in this case, so he or she funds their own account.
How much may be contributed to a SEP?
The same limits on contributions made to employees’ SEP-IRAs also apply to contributions made to a self-employed individual’s SEP-IRA. Contributions must be made in cash (no stock). The contribution deadline is usually April 15 of the following year — i.e., you have up to April 15, to contribute for the past year’s SEP IRA. The table below shows the SEP contribution limits over the last few years along with some other key figures
|SEP Employer Contribution Limit||$57,000 or 25% of compensation||$56,000 or 25% of compensation||$55,000 or 25% of compensation||$54,000 or 25% of compensation||$53,000 or 25% of compensation||$53,000 or 25% of compensation|
|SEP minimum compensation||$600||$600||$600||$600||$600||$600|
|SEP annual compensation limit||$285,000||$280,000||$275,000||$270,000||$265,000||$265,000|
Can catch-up contributions be made to a SEP?
Generally No. SEPs are funded by employer contributions only. However, catch-up contributions can be made to the IRAs that hold the SEP contributions if the SEP-IRA documents allow.
What if the Employee already contributes to another 401K or IRA Plan?
You are eligible to contribute to a SEP IRA even if you are already covered by a retirement plan at your full-time job or have retirement plans from other employment sources. However the lower 401K or IRA limits are still applicable to these kinds of plans. In determining this limit, contributions for employees to all defined contribution plans of the employer, which includes SEPs, must be included. So if you contributed $10,000 to a 401k, your maximum SEP-IRA would be $39,000 or 25% of your eligible compensation,’ whichever was less. If you are self-employed, however, the definition of ‘eligible compensation’ gets more involved, the result being that the maximum percentage is 20% (not 25%). You’ll find more details in IRS Publication 560.
How is a SEP established?
A SEP is established by adopting a SEP agreement and having eligible employees establish SEP-IRAs. There are three basic steps the IRA requires in setting up a SEP, all of which must be satisfied.
– 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 (banks, insurance companies, and other qualified financial institutions have templates/prototypes to help you with this)
– 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.
– 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.
A SEP can be set up for a year as late as the due date (including extensions) of the business’s income tax return for that year. Unlike a 401k where the employer has to file a IRS Form 5500, that is not required for the SEP IRA. For any employer that has gone through this process, they realize the time and effort it takes to make sure this form is filed correctly.
If you’ve contributed more than the annual limits to an employee’s SEP-IRA, find out how to correct his mistake.
SEP IRA vs 401K or Traditional IRA plan
A SEP provides high maximum contribution limits, but an Individual 401k may allow a greater contribution at the same income level. Also, for those age 50+ there isn’t an additional $5,500 catch-up contribution provision like there is with the Individual 401k. A final point to consider is IRS rules do not permit loans with a SEP IRA. A SEP IRA is the right choice if you aren’t in need of a loan and don’t anticipate needing one in the future.
A good summary of the differences are provided via the Motley Fool. 2016 limits are used in this example, so please refer to the table above for current year limits. The contribution limits if you have both a 401(k) and SEP IRA depend on whether one, both, or neither account is from an employer.
- If you are an employee and you have both a 401(k) and SEP IRA through your employer, your deferral contribution to the 401(k) cannot exceed $18,000 ($24,000 if over 50) in 2016, and the total contributions to both accounts cannot exceed $53,000 ($59,000 including 401(k) catch-up contributions).
- If you are self-employed, you can open a solo 401(k) and SEP IRA, but your total contributions are limited to $53,000 ($59,000 including 401(k) catch-up contributions), unless the “25% of compensation” limitation discussed earlier applies.
- Finally, if you have a 401(k) through an employer and have a SEP IRA for your self-employment income, each contribution is treated separately. You can defer up to $18,000 of your salary into your 401(k) and your total contribution is limited to $53,000 ($59,000 if over 50) after your employer contributes, as discussed earlier. Since your SEP IRA contributions are considered to come from the employer, none of it counts toward the $18,000 salary deferral limit, so you can contribute up to $53,000 or 25% of your earnings, whichever is less.
However, there is no harm starting with a SEP-IRA and then converting to an Individual 401k. All that is needed to transfer retirement assets from a SEP IRA to a new Individual 401k is some minor administrative paper work.