What are details of a Simplified Employee Pension IRA?
ASimplified Employee Pension (SEP) plan lets self-employed individuals and small business owners establish individual retirement accounts, called SEP IRAs, for themselves and their employees.
The SEP IRA works like a traditional IRA, but there are additional rules and benefits to understand and consider.
The benefits of SEP IRAs
SEP IRAs are defined contribution retirement plans.
Think of SEP IRAs as part 401(k) plan and part traditional IRA, except employers make the contributions. A SEP IRA offers tax-deferred growth for contributions, and withdrawals are taxed as regular income when employees make withdrawals in retirement. SEP IRAs differ from Traditional IRAs. They potentially offer higher contribution limits because an employer’s total contribution limit is higher than an individual’s traditional IRA contribution limits.
Employers can contribute yearly up to the lesser of $57,000 or 25% of an employee’s income. Self-employed individuals or employers contributing to their own SEP IRAs can contribute less, after accounting for tax requirements.
Small business owners with employees besides themselves who choose a SEP must open accounts for all eligible employees and contribute the same percentage of compensation to each qualifying employee’s SEP IRA, including their own.
SEP IRAs give business owners flexibility regarding when they make contributions.
Business owners also get tax deductions for their SEP IRA contributions.
KEY FEATURES OF SEP IRAS Employee contributions
Some SEP IRA plans allow employees to make traditional IRA contributions to their SEP IRA account. This reduces the amount the employee may contribute to other IRAs.
Individually, you are only allowed to contribute up to $6,000 in 2020 ($7,000 if you are 50 or older) to all IRAs, including traditional, Roth and SEP IRAs.
Vesting
Employer contributions to an employee’s SEP IRA vest immediately.
The employee has ownership of all assets in the account as soon as an employer makes a contribution.
The rules of IRA withdrawals still apply. Workers generally can’t take the money early without paying penalties. They can roll the funds into another IRA.
Loans
SEP IRAs, unlike 401(k) plans, aren’t permitted to make loans to participants.
Who can open?
Any sole proprietor, partnership, corporation or nonprofit organization can set up a SEP IRA, but it’s best suited to sole proprietors and small businesses with just a few employees.
Which employees qualify?
Employers must include all employees 21 or older, have performed services for the business in at least three of the last five years and have received at least $600 in compensation from your business for the year.
This includes part-time employees, seasonal employees and any who left the business during the year.
Some employees may be excluded from a SEP IRA.
2020 contribution limits
Contributions to an employee’s SEP IRA cannot exceed the lesser of either 25% of their compensation or $57,000 in 2020.
If you are self-employed and making SEP contributions for yourself, different contribution limits apply.
All SEP contributions must be made in cash and are immediately vested in employee SEP accounts. If you have more than one defined contribution plan for employees, the limits apply to contributions made to all accounts.
Calculating your contribution as a self-employed person
If you’re self-employed and making SEP IRA contributions on behalf of yourself, the same limits apply as for those with employees, but you’ll calculate the maximum deductible contribution differently.
Your contribution max is calculated as net profit minus one-half of the self-employment tax and your SEP contribution. This will reduce the percentage of your pre-adjusted salary you can contribute.
When and how to contribute?
Employers and sole proprietors can contribute to a SEP IRA annually, but they don’t have to contribute to a SEP IRA yearly.
When revenues are down, they can choose to contribute less to the SEP IRA or not to contribute anything in that tax year at all.
When employers do contribute, they must contribute equally for all participants, including themselves.
Contributions for a tax year must be made by that year’s federal tax filing deadline. If you file for an extension on your taxes, you must contribute before the end of your extension period.
What are the withdrawal rules?
When you withdraw from your SEP IRA in retirement, you pay taxes on any withdrawals based on your current income tax bracket. Money can be used penalty-free for any purpose after age 59 ½, the federal retirement age.
Early withdrawal rules
Except under certain circumstances, if you withdraw money from a SEP IRA before age 59 ½, you’ll owe income tax on the entire amount withdrawn, as well as a 10% early withdrawal penalty, unless you qualify for an exception.
Exceptions to the early withdrawal penalty
The 10% early withdrawal penalty can be avoided if the money is taken out for any of the following reasons:
• First-time home purchase (up to $10,000)
• Birth or adoption of a child (up to $5,000)
• Qualified higher education expenses
• Qualified medical expenses
• Health insurance premiums when unemployed
• Substantially equal payments
• Withdrawals by a beneficiary, after the account holder has died Keep in mind that you (or your beneficiary) will still owe income tax on any withdrawals from your SEP IRA.
As part of the 2020 CARES Act, you can withdraw up to $100,000 from your SEP IRA penalty-free if you face coronavirus-related hardship.
Any amount of that withdrawal that you redeposit in your SEP-IRA or another retirement account within three years will also escape income taxes, although you may have to file an amended return.
How do I open?
Opening a SEP IRA requires that you put in place a written agreement to provide benefits to all eligible employees.
The agreement requires the name of the employer, what’s required for employee participation, the signature of a responsible official and a definite allocation formula. Many brokerages require you to have an Employer Identification Number (EIN) to open a SEP IRA.
You may set up a SEP IRA with a bank, insurance company, mutual fund company or other financial institution that offers IRA accounts. You must apply to open the SEP, and each eligible employee must also submit an application.
A SEP can be established any time before a company’s annual tax filing deadline and can be used to make contributions for that tax year.
If there are eligible employees, employers must provide them with disclosures about the plan and allow them to enroll. This is true on a rolling basis: Once an employee becomes eligible, they must be informed.
Each employee should receive a copy of the agreement containing participation rules and a description of how employer contributions may be made to the IRA, along with a copy of the completed Form 5305-SEP and a yearly statement showing any contributions to the plan.
Investment options
Funds saved in a SEP IRA may be invested in any security, including mutual funds, exchange-traded funds (ETFs) and individual stocks and bonds.