SEP IRA Plan: What is Simplified Employee Pension Plan?

KEY TAKEAWAYS

• A simplified employee pension plan (SEP) is an individual retirement plan that allows employers to contribute to individual retirement accounts (IRAs).
• SEP IRAs are commonly used by self-employed individuals or by small businesses to  contribute to their retirement savings.
• The contribution limit for a SEP IRA is set annually. It is commonly higher than a standard IRA or a 401(k). 

What Is a Simplified Employee Pension (SEP) IRA Plan?

A simplified employee pension plan (SEP) allows an employer to contribute to an individual retirement account (IRA). Each eligible employee’s plan receives discretionary contributions from the employer, who can deduct contributions made to a SEP IRA from taxes. The employer can also contribute to his own SEP IRA under this plan.

How a Simplified Employee Pension Plan (SEP) Works

Smaller businesses are eligible for a tax credit to help with the costs of establishing a 401(k) plan or SIMPLE IRA with auto-enrollment under the Setting Every Community Up for Retirement Enhancement (SECURE) Act. This act was passed on December 20, 2019. This is in addition to the existing start-up credit.

Compared to normal IRAs, SEP IRAs frequently have larger yearly contribution caps. They are essentially a cross between both a 401(k) and a standard IRA. This is in that they can both receive employer contributions, much like the latter. Additionally, those employer contributions are instantly vested.

A SEP IRA doesn’t come with a lot of the operating and start-up costs that many traditional employer-sponsored retirement plans have. This makes it an attractive option for many small companies. Additionally, many self-employed individuals set up a SEP IRA to enable them to contribute more to their own retirement than a traditional IRA permits. In order to start a SEP IRA, an employer has to execute a written agreement describing the plan’s benefits, share the information with their employees, and open an IRA for each of the participating employees.

For tax reasons, SEP IRAs are treated similarly to standard IRAs and offer the same investment possibilities. SEP IRAs are subject to the same transfer and rollover regulations as standard IRAs.

An employer can deduct the number of contributions made to SEP IRA accounts from its taxes. Additionally, the company is not obligated to make a donation every year; instead, decisions regarding whether to contribute and what the contribution amount will be each year are flexible. A SEP IRA also enables employers to forego payments in years where their business underperforms or when income is down.

Who Can Participate in a SEP IRA Plan?

Sole proprietors, corporations, and partnerships are all eligible to participate in a SEP IRA plan. In terms of income, the eligible compensation contribution limit in 2023 is $330,000. This is up from $290,000 in 2021. 

What Are the Rules for a SEP IRA Plan?

Even if they would otherwise be qualified under the plan’s criteria, certain employees may be prohibited from taking part in a SEP IRA by their employer. Employees who, for instance, get retirement benefits under a collective bargaining agreement with a union may be excluded. Nonresident immigrant workers may also be excluded as long as their employer does not pay them U.S. wages or other forms of service remuneration.

With the exception of any specific restrictions placed on standard IRAs, SEP contributions and profits are retained in SEP IRAs and may be taken whenever desired. Withdrawals are taxed in the year they are made. A participant is typically subject to an additional 10% tax on withdrawals made before the age of 59 and a half. The SEP doesn’t allow participants to borrow up to the lesser of $50,000 or 50% of their vested balance. 

The transfer of SEP contributions and earnings to other IRAs and retirement plans is permitted tax-free. At some point, SEP contributions and earnings must be distributed in accordance with the IRA’s mandated minimum distributions regulations which will happen after the retirement age is achieved.

To be included in the SEP plan employees must have reached the age of 21; worked for your company for at least three of the previous five years, and received at least $650 in 2022 from your business. 

What Are the Contribution Limits for a SEP IRA Plan?

The contributions that are made by employers are not allowed to exceed the lesser of $66,000 or 25% of an employee’s compensation. When a business is run as a sole proprietorship, the owner will pay themselves a wage and also make a SEP contribution. The SEP IRA contribution is limited to 25% of net wages. Net wages are calculated as your wages minus half of your self employment tax and the contribution to your own SEP IRA.

Advantages of a SEP IRA Plan

There are a number of advantages of a SEP IRA plan. Here are some of the common ones:

• You can maximize saving through contribution limits.
• The funding is flexible, meaning you can decide each year which amount to contribute.
• You can reduce your tax bill with deductible contributions. 
• It allows you to prepare for your financial future as well as help employees prepare for their retirement.
• You and your employees can benefit from deferring the tax payments on the contribution until retirement age. 

Disadvantages of a SEP IRA Plan

The main disadvantage of SEP IRAs is that they don’t allow for employee contributions. Other employer-offered plans such as simple IRAs and 401(k)s allow employees to set aside a portion of their paycheck before taxes. However, with a SEP, employees have to completely rely on their employer to set aside the contribution for them. This could mean that as an employee, you would have to open a separate retirement account if you don’t believe that the employer’s contributions will be sufficient for your retirement.

Summary

SEP IRA plans are a good idea for any small business owner or self-employed person that is looking to contribute to their retirement goals. 

It is important to think ahead for the future when you are running your own business. Retirement plans can often be forgotten when you are focusing on your business. Therefore, making the most of a SEP IRA plan can be a good way to prepare for the day you shut up shop and retire by helping you to expand your retirement portfolio.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.