Finances and Taxes

What is a SEP-IRA?

Nayo Carter-Gray  

A Simplified Employee Pension (SEP) plan is an individual retirement account (IRA) that is set up by employers on behalf of their employees. Good news, if you are self-employed you are considered employed by the business and can make contributions to this type of plan on your own behalf. 

SEP-IRAs are especially attractive to small business owners because they don’t have the administrative restrictions or costs that many other conventional employer-sponsored retirement plans require in order to get set up. 

Setting up SEP-IRA accounts

Employers or small business owners can set up new accounts anytime on or before the business tax return due date, including extensions. Contributions into the plan follow these same timing rules. 

To create a SEP-IRA plan in your company, an employer or small business owner only needs to fill out Form 5305-SEP, Individual Retirement Account Contribution Agreement, for each eligible employee to maintain with their human resource records. This document serves as notice to the employee they are eligible for the plan, and that contributions will be made on their behalf. Please note that this form does not get filed with the IRS. 

Form 5305-SEP is less than half a page and looks like this:

Although only employers and the self-employed can make contributions to this type of plan, employees are free to move or withdraw the funds at any time.     

Eligibility requirements 

The standard rules for employee eligibility require that employees:

  • Be 21 or older,
  • Have worked for the employer in at least three of the immediately preceding five years, and
  • Have received at least $600 in compensation for the year

Employers can choose to make these criteria less restrictive, but not more restrictive. (For instance, you may choose to provide a SEP-IRA to employees who have worked for your company for at least six months and earned $500 or more.) Please note that eligible employees also include those who were separated from service or that passed away during the year. Unfortunately, there isn’t an end-of-year employment requirement rule that negates your responsibility as an employer to contribute for terminated employees.

Employers are only allowed to exclude employees from the plan if:

  • They are covered by a collective bargaining agreement,
  • Are a non-resident alien who didn’t earn US income from you, or
  • Received less than $450 in compensation for the year

Compensation included in determining SEP contributions for employees include wages, tips, and other compensation subject to income tax withholdings. 

SEP-IRA contribution rules

There are special rules to follow when making contributions for yourself or your employees to these types of plans. Contributions must be the same percentage of compensation for every eligible employee. If you are self-employed and have employees, you must contribute the same percentage for yourself as well as your eligible staff. This means if you contribute 15 percent of your salary to your SEP-IRA, you have to do the same for all eligible employees. This type of plan cannot favor highly compensated employees. 

Although an employer must use the same percentage of compensation for every eligible employee, the employer does not have to contribute the same percentage amount every year.  You have the option to change the percentage annually, as long as every employee gets the same percentage contribution. 

Also, an employer can choose to skip contributing altogether, as long as none of the employees gets a contribution that year. This flexibility can be beneficial to employers in years when profits may not be as high, but it hurts employees because they can’t contribute to the plan themselves. Also, while there’s no requirement for an employer to notify employees if the contribution rate will be altered from prior years, communicating any changes is generally recommended.

The annual contribution limit to a SEP-IRA is whichever one of these is less:

  • $57,000 (for 2021), or 
  • 25 percent of the employee’s gross compensation

Self-employed business owners must make a special computation to calculate the maximum allowed contribution. Their amount is: 20 percent of net self-employment income, minus half of the self-employed tax deduction. This calculation does not include contributions for employees of your sole-proprietorship or single-member LLC business. To complicate matters further, you will report these two separate amounts in two different places on your individual tax return.

When computing any limits, you must add all contributions to all defined benefit plans maintained by the same and any related employer. 

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Tax deductions

Contributions to SEP-IRA plans are tax-deductible to the employer and are not included in the employee’s W-2 wages. If the employer makes a contribution after the tax year has passed, then they can stipulate which year they’ll take the deduction: the tax year to which the contribution was allocated or the year in which the contribution was made. For example, if an employer makes a March 2021 contribution that’s allocated to the 2020 tax year, they may apply the deduction to either year: 2020 or 2021. 

Distribution rules

SEP-IRA distributions are treated exactly the same way as distributions from traditional IRAs. 

They are subject to 10 percent penalty for early withdrawal (unless exceptions apply), 10 percent penalty on excess contributions, and 50 percent penalty for excess accumulation if required minimum distribution (RMD) rules aren’t followed. However, you can avoid a penalty for excess contributions if the excess contributions are withdrawn from the plan no later than the due date of the tax return.

For example, let’s say you (the business owner) contribute $20,000 to your SEP-IRA in 2020, but when you calculate your net earnings for the 2020 tax year in, say, March 2021, you realize that you contributed $2,000 over the max amount allowed. As long as you take out that $2,000 before April 15, 2021 and make the necessary adjustments for any interest earned on it, then you won’t be faced with a penalty. 

Rollover rules

Rollovers to SEP-IRA accounts are allowed from other qualified retirement plans except Roths. SEP-IRAs cannot be rolled over into designated Roth Accounts tied to 401(k), 403(b) or 457(b) accounts.

Investment rules

SEP-IRA plans follow the investment vehicle rules of traditional IRAs. These types of plans do not allow for investments in life insurance or collectibles.  You can learn more about that here.

Terminating a SEP-IRA

There are no specific rules to terminate SEP-IRA plans.  If you do decide to terminate the plan, you can just stop funding the account. It is recommended that you notify your employees if you discontinue the plan, but you will not need to notify the IRS.   

SEP-IRA at-a-glance

Glossed over a bit while reading this post? Here’s a quick recap.

 The advantages of SEP-IRA:

  • Employees are fully vested in the account at set up and when contributions are made
  • Employers may benefit from a  tax deduction and/or deferral of income
  • Deductible contributions are not subject to AGI phase out rules for employees covered by other employment plans
  • The maximum contribution for higher income employees is usually greater than an individual IRA
  •  The plan can be set up and funded up to the due date of the tax return, including extensions
  • There are no annual reporting requirements

 The disadvantages of SEP-IRA:

  • Employer funds 100% of an employee’s contribution (except SARSEPs established prior to 1997)
  • Low-income employee contributions may be much lower than contributions into a traditional or SIMPLE IRA 

In conclusion, SEP-IRA plans are a popular retirement savings option for business owners and employers alike because of their ease of setup and tax benefits. Not only will employers love attracting top talent because of the benefits the company offers, but employees will appreciate the flexibility of being fully vested and able to manage their own investments on the day the plan is set up.  

A final note: be sure to sync up with your accountant or CPA to ensure that your company is compliant with all the rules and regulations related to SEP-IRAs. 

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Nayo Carter-Gray
Nayo Carter-Gray Making Accounting a Little Less Taxing® for small business owners is Nayo Carter-Gray’s goal as owner and founder of 1st Step Accounting LLC. A self-proclaimed techie, Nayo decided a virtual accounting practice was the best way to experience her love of travel and still help small business owners across the US to reduce the stress of managing their disorganized financial systems. Mrs. Carter-Gray is an Enrolled Agent and a QuickBooks Online Advanced Certified Pro-Advisor. She was named one of Hubdoc’s 2017 and 2018 Top 50 Cloud Accountants in North America and handpicked to sit on the 2018-2019 Intuit Accountant Council. Mrs. Carter-Grat was also recently named one of Forbes Top 100 Tax Twitter accounts to follow and one of the Top 50 Women in Accounting by Practice Ignition.

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