After Madison posted about her Solo 401(k) woes, a reader, Lee, suggested she look into a SEP-IRA instead. Let’s take a step back and explore 3 different types of retirement plans ideal for small business owners and the self-employed. We’ll start the series with an in-depth look at the SEP-IRA.
SEP stands for Simplified Employee Pension. A SEP uses an IRA to “hold” the contributions, is easy to establish, and is often more flexible than a qualified plan. It is ideal for sole proprietors and small businesses.
- Coverage: If you are a business owner and contribute to an SEP-IRA plan in a given year, you must make contributions on behalf of all employees who are 21 or older, have worked for three years or more, and have earned more than $500 ($550 in 2010-2012) during the year.
- Contributors: A SEP-IRA is funded by employers only – employees cannot contribute.
- Contribution limits: From 2009-2011, the maximum SEP-IRA contribution is the lesser of 25% of an employee’s compensation or $49,000 (increasing to $50,000 in 2012). The maximum contribution is reduced by any employer contributions to a profit-sharing plan, and vice versa – together, employer contributions to a SEP-IRA and a profit-sharing plan are capped at the lesser of 25% of compensation or $49,000 (or $50,000 in 2012). For self-employed business owners, “compensation” refers to earned income, which excludes self-employment taxes and contributions to other employees.
- Deadlines: A SEP-IRA can be established and funded for a given calendar year up to the tax-filing deadline for that year, including extensions. For sole-proprietorships and partnerships, the final extension date is October 15 of the next calendar year, so you can establish and fund a SEP-IRA for one year as late as October 15 of the following year.
- Taxation: Employer contributions to a SEP-IRA are deductible from the employer’s income, and are not included as employee income at the time of the contribution. Taxes on withdrawals are explained below.
- Vesting: There is no vesting period for SEP-IRA contributions. An employee has access to 100% of the contributions as soon as they are made.
- Withdrawals: Because SEP contributions are made to IRAs, the withdrawal rules are the same as those for traditional IRAs. Employees can withdraw at all times, including while they are employed. Withdrawals will be subject to ordinary income tax regardless of age or reason for withdrawal. In addition, SEP-IRA withdrawals will be subject to a 10% early withdrawal penalty if the account owner is younger than 59½. Some exceptions to the 10% penalty apply.
- SEP contributions are made to traditional IRA accounts and cannot be made to Roth IRA accounts. Once contributions are made, the account can be rolled into a Roth IRA – the rolled over balance will be subject to income tax.
- Employer contributions to SEP-IRAs can be made at the employer’s discretion, meaning that an employer can establish the plan without being obligated to fund it each year.
Establishing a SEP-IRA
To establish a SEP-IRA, an employer must execute a formal, written agreement to provide benefits to all eligible employees, and inform employees of that agreement and the account establishment. An individual SEP-IRA must then be established for each eligible employee. Any financial institution that offers traditional IRAs should be able to set up SEP-IRAs.
Sole proprietors or employers with just a few employees love SEP-IRAs because they are easy to establish and require little effort from year to year. The ability to choose whether or not to make contributions is also ideal for business owners with highly variable income from year to year. Finally, the late contribution deadline makes it easy to use a SEP-IRA to lower your tax bill after you calculate it.
Because a SEP-IRA requires contributions to all employees, it is not a good plan for someone with employees who only wants to beef up his or her own retirement savings. It is also not good for businesses with employees that want to be able to contribute to their own accounts. Finally, the SEP-IRA may not maximize savings opportunities for business owners because of the way self-employment income is treated.