Simplified Employee Pension Plans (SEPs)
The simplified employee pension plan (SEP), also known as a SEP IRA, is what the name suggests, a pension plan that can easily be set up by a small employer for both the owner and its employees or for the self-employed. A SEP-IRA is set up with a financial institution for each participant to receive the contributions by the employer, and the participant owns and controls the SEP-IRA.
A SEP can be set up with a qualified financial institution and does not require IRS approval. If the business provides no other qualified retirement plan other than another SEP and if leased employees are not used and eligibility is extended to all common-law employees, then the employer may use a model SEP in Form 5305-SEP, Simplified Employee Pension — Individual Retirement Accounts Contribution Agreement, a copy of which must be given to each eligible employee. However, affiliate groups or other groups under common control cannot use Form 5305-SEP. The employer must also give eligible employees an annual statement showing the employer's contributions to the employees' SEP-IRA's and of any excess contributions.
The deadline for both setting up and contributing to a SEP is by the due date of the return, including extensions. For a SEP established before 1997, a salary reduction contribution can be made on behalf of the employees; otherwise a salary reduction arrangement for employees may be provided by a SIMPLE IRA established after 1996.
All employees must be allowed to participate in the SEP, unless they are part-time or they are covered by a union agreement, and who:
- reached age 21 by year-end;
- were employed at least 1 day in each of 3 of the 5 prior years; and
- earned at least $600 in both the current and the previous year.
However, employees covered by union agreements or nonresident alien employees who have not received any United States sourced compensation may be excluded. The employer can extend eligibility, but it cannot restrict it to fewer employees than would be allowed by the above rules.
The Secure Act 2.0, passed at the end of 2022, allows SEPs, starting in 2023, to have Roth accounts, which will allow workers to make nondeductible Roth contributions that will grow tax-free and will not be taxable when withdrawn. These Roth accounts work much the same as Roth accounts for 401(k)s and Roth IRAs.
Contributions are deductible by the employer or by the self-employed and they are not subject to ordinary income taxes for the employees. However, they are subject to employment taxes. Contributions do not have to be made every year but they must be based on a written allocation formula and not discriminate among employees or owners. The contribution must be paid to every eligible employee, including any who die or terminate their employment before the contribution. Contributions for common-law employees are deductible as a business expense, but the deduction for the self-employed or business owners is an above-the-line deduction for gross income, which saves on the marginal income tax but not the self-employment tax.
Contributions to a SEP are deductible in the tax year for which they were made, including contributions made within the year itself and any contributions made for a prior year that were made between January 1 and the due date of the tax return, including extensions. If the taxpayer uses a fiscal year, and the SEP is maintained on a calendar year, then the taxpayer deducts the contributions for the fiscal year containing the end of the calendar year. So if the taxpayer's fiscal year ends on July, 2020, then the SEP contributions for calendar year 2019 are deducted on the taxpayer's 2018 tax return.
There are contribution limits based on a percentage of compensation and upon statute, whichever is lower. Furthermore, the contribution limits do not include any contributions to traditional or Roth IRAs. Unlike IRAs, contributions can be made for employees or the self-employed who are older than 72, but those participants must still receive required minimum distributions. If the employer has more than one defined contribution plan, then any annual additions to an account for any given employee are limited to the lesser of the statutory limit or 100% of the participant's compensation. Employer contributions are not reported on Form W-2 unless they were made under a salary reduction arrangement.
|Employer's Contribution Rate
1 + Employees' Rate
So if the business owner wants to claim the full 20% of net business income, then the contribution rate for employees must also be set to the maximum employee rate of 25%:
Employer's Contribution Rate = .25/1.25 = .20 = 20%
So a contribution rate of 25% means that the employer would contribute 25% of the employees' compensation to the plan, which is deductible as a business expense on Schedule C, Profit or Loss from Business or Schedule F, Profit or Loss from Farming. The business owner may also deduct any trustee fees associated with the retirement plan in addition to the maximum contribution deduction.
|Deduction from Self-Employment Tax
|Net Earnings for Determining Contribution Deduction
|= Net Profit − Self-Employment Tax Deduction
|Plan Contribution Rate
|Rate for Self-Employed
|= Plan Contribution Rate/(1+ Plan Contribution Rate)
|Tentative Contribution Deduction
|= Net Earnings × Rate for Self-Employed
|Statutory Contribution Dollar Limit
|= Lesser of Tentative Contribution Deduction or Statutory Contribution Dollar Limit
The maximum rate for the self-employed is 20% if the employee rate is 25%. Note that to make the maximum contribution, the self-employed must earn at least 5 times the maximum contribution dollar limit and an employee must earn at least 4 times the dollar limit.
Excess contributions over the contribution limit are nondeductible and may be subject to a 10% excise tax.
Tax tip: a self-employed taxpayer whose income is significantly less than the income required to make the maximum contribution can make larger contributions to a 401(k) plan, by making both the employee contribution plus the employer's contribution.
Distributions are generally subject to the same distribution rules as traditional IRAs, including being able to roll over amounts from one IRA account to another, and the assessment of taxes on excess contributions or on early withdrawals. SEP-IRA's also have required minimum distributions (RMD), with a 50% tax penalty assessed on the difference between the RMD and the amount actually withdrawn. The employer cannot prohibit distributions from the SEP-IRA nor can it require that its employees keep the money in the account after it has been contributed.
A SEP-IRA may be disqualified because of a prohibited transaction, such as borrowing money from the account. If the SEP-IRA becomes disqualified, then the account owner must include the fair market value of the assets in the account on the 1st day of the calendar year in which the disqualification occurred in his income. So if an employee's account becomes disqualified because of borrowing money from the account, and the account only has stock worth $10,000 on January 1 of the year of the disqualification, then the entire $10,000 is treated as having been distributed in that year. If the employee is younger than 59½, and no exception applies, a 10% tax penalty will also be assessed on the January 1 account value minus the taxpayer's basis in the account.
However, the 10% excise tax does not apply to contributions that were necessary to meet minimum funding requirements for a money purchase pension plan or defined benefit plan, even if the contribution is more than the earned income from the business. The tax on nondeductible contributions is figured and reported on Form 5330, Return of Excise Taxes Related to Employee Benefit Plans.
Salary Reduction Simplified Employee Pension (SARSEP)
Some employers may have a Salary Reduction Simplified Employee Pension (SARSEP) in which contributions to the SEP-IRA are made through a salary reduction rather than given the employees the cash. However, SARSEP's cannot be set up after 1996, but any employers that already had it set up can continue to use it, even for new hires.
Starting in 2018, under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, a conversion from a traditional IRA, SEP, SIMPLE, 401(k), or 403(b) accounts to a Roth account cannot be recharacterized back to a traditional IRA.