What are SEP Plans – Simplified Employee Pension Plans?
A simplified employee pension, more commonly known as a “SEP plan”, is an employer sponsored plan where the employer makes contributions on behalf of it’s employees. Those contributions are tax-deductible for the business and provide tax-deferred investment growth just like a 401k or IRA. Distributions are then taxable as ordinary income upon withdrawal after age 59 and 1/2. Distributions prior to age 59 and 1/2 are not only taxable, but face a 10% tax penalty unless the account owner qualifies for a hardship provision.
How much can I contribute to a SEP plan?
Contributions are generally made pre-tax, and excluded from the employees gross income. Contributions are limited to the lesser of:
- 25% of the participants compensation (compensation is limited to $265,000 for 2017), or
- $54,000, which is the Section 415 annual additions limit
Compensation includes bonuses and overtime income. SEP contributions exceeding the maximum amounts are included in taxable income.
If you’re an unincorporated employer, the contribution comes from “earned income”. There are some special calculations to determining just what that earned income amounts to. To calculate your exact contribution amount, the IRS has a SEP contribution worksheet here.
If you’re self-employed, and most SEP plan sponsors are, there are special calculations to determine exactly how much you can contribute. This is because Social Security contributions are made by both the employer and employee. Since both contribute to Social Security, only certain amounts of income are includable for the SEP contribution calculation.
Nondiscriminatory employer contributions under a SEP MUST be made for:
- Each employee who is 21 or older, who has
- Worked for the employer at least 3 of the immediately preceding 5 years, and
- Received at least a specific minimal dollar amount of compensation.
Employee participation requirements
Small business owners must include employees in the SEP plan if:
- They’re at least 21
- They’ve been employees in the business for at least 3 of the last 5 years
- They’ve received at least $600 in compensation (for 2016 and 2017)
Those are the most restrictive SEP plan participation requirements possible per IRS rules. You can however ease those restrictions if you’d like. The guidelines – whether you follow the basic rules above or loosen them – must be applied to ALL employees. You cannot favor certain employees over others.
You can exclude some employees, including:
- Those covered by a union agreement if retirement benefits were bargained for in good faith by you and the union
- Nonresident aliens who have no US compensation
What’s does “top-heavy” mean?
Top heavy means too much of the plan’s funding is going to the key employees of the company. The IRS wants small business owners to “spread the wealth” after all!
If the SEP is top heavy, the employer must make contributions to the employee’s accounts. Those contributions must not be less than 3% of the employees compensation.
If the key employee receiving the largest contribution is less than 3% of compensation, the contribution rate for that employee is used to determine the minimum contribution for non-key employees.
Employees can contribute to their SEP plan too!
Employees making such a contribution must realize that their gross income and filing status determine whether such a contribution is deductible, and their respective contribution limits (referring to the phase out ranges). Employee contributions are made just as any other IRA contribution would be made.
Employees contributing to their SEP plan have limits on the amount they can contribute. Those limits apply to their traditional IRA, ROTH IRA, and SEP IRA combined. The yearly maximum is $5,500 for 2017, or $6,500 if the individual is over 50 years old and catch up contribution limits apply.
How do I open a SEP plan?
To establish a SEP plan, you need to complete form 5305-SEP. You can do this by opening up a SEP plan account with a brokerage firm – they’ll usually have all of the forms necessary.
The form 5305-SEP is known as the Simplified Employee Pension individual Retirement Accounts Contribution Agreement. You don’t need to file that form with the IRS, but instead you retain it for your records and evidence the SEP Plan has been established. You must also give all eligible employees a copy of that form 5305 SEP.
What’s the SEP plan deadline?
An employer may establish a SEP Plan for a particular year (i.e. 2017) as late as their tax filing due date, plus extensions. SEP Plan contributions must also be made by the employer’s tax filing due date, plus extensions for that particular year.
Calendar year corporations have a tax filing deadline of March 15. If they elect to have their return extended, they can actually “push back” opening the SEP and funding it until September 15 of that same year.
What if I contribute for my employees and they leave?
All SEP plan contributions are vested immediately. This means that once the employer makes a contribution to an employee, that money is theirs to keep in their own account regardless of whether they quit tomorrow or not!
Does a SEP plan make sense for me and my business?
The SEP plan is a great plan for small businesses who want to build retirement wealth for owners and employees alike! Each individual manages his or her own investment accounts. You as an employer can open your SEP account and invest in stocks, bonds, and mutual funds. Anything your brokerage firm can facilitate, you can invest your SEP in.
SEP’s are super simple to open and manage:
- Any sized business can start a SEP by completing form 5305 – SEP
- There’s no annual filing requirement for SEP’s
- Only the employer makes contributions to SEP-IRA’s for each employee
- SEP IRA participants are always 100% vested
The contributions can be made annually, and are very flexible. This makes a SEP plan nice for businesses with large variances in cash flow. They can wait until their year is over then decide how much to fund the SEP with.