SEP IRA for Employees
A SEP IRA for employees is a retirement plan option that allows very small businesses and entrepreneurs to defer up to $56,000 annually or 25% of their employees’ compensation. Only an employer can contribute to a SEP IRA, and they are required to make proportional contributions to all full-time employees. SEP IRAs are tax deductible and discretionary for employers—meaning they only have to contribute when they choose to. Employees must be at least 21 years of age, have worked for the business for 3 of the last 5 years, and received at least $600 in compensation to be eligible for a SEP IRA.
One of the best fringe benefits you can offer as a small business owner is a retirement plan for your employees. The benefits are numerous: You can attract and retain employees, deduct contributions from your taxes, and grow an asset tax-free. If you’re in the market for a retirement plan, one option you might consider is a SEP IRA for employees.
Depending on your business type, a SEP IRA, or simplified employee pension plan, can be very beneficial to you and your employees. Let’s learn a bit more about SEP IRA’s to understand which businesses would benefit from offering this type of retirement plan. We’ll also go over how to set up a SEP IRA and general rules and regulations around this unique type of retirement plan.
What Is a SEP IRA for Employees?
A SEP IRA is an employer-sponsored retirement plan that allows business owners and the self-employed to defer up to $56,000 annually or 25% of their employees’ compensation. With a SEP IRA, only the employer can contribute to the plan, and they are required to make proportional contributions to all full-time employees.
The benefit of offering a SEP IRA for employees is that it allows you to defer large sums of money to a retirement plan. SEP IRAs are often used by very small business and self-employed individuals in lieu of 401(k)’s because 401(k)’s have high administrative fees and require heavy maintenance. For small businesses and entrepreneurs, this is less than ideal. While they could open an IRA (individual retirement account), the limit on what you can defer to an IRA is $6,000 in taxable income annually (as opposed to a 401(k)), which allows for up to $56,000 annually).
To allow small businesses and entrepreneurs the opportunity to contribute large sums to a retirement plan without facing heavy fees, SEP IRAs were created. The only fees associated with SEP IRAs for employees are an annual custodial fee on each employee account (typically ranging from a few dollars to up to $2,000) and whatever the employer decides to contribute to the plan.
Keep in mind that SEP IRA contributions are tax-deductible and discretionary for a business owner, meaning they don’t have to contribute to a SEP IRA in a given year if they don’t want to. This means a SEP IRA is a good thing if your business is cyclical in nature—meaning that you have high and low volume times—because you can reduce the amount of the contribution. Again, the employer is the only one that can establish and contribute to a SEP IRA, and they must contribute a proportional percentage to all employee accounts (although the amount they contribute can vary from month to month). The fact that they have to contribute a proportional percentage can also make a SEP IRA an expensive plan for businesses with many employees. This is why large businesses typically opt for a 401(k), while small businesses use a SEP IRA.
How to Set Up a SEP IRA for Employees
It’s fairly easy to start up a SEP IRA for employees; it comes down to three basic steps:
1. Adopt a Formal Written Agreement
To start, place a formal written agreement by filling out and signing one of the following 3 documents:
- The 5035-SEP (Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement)
- An IRS-approved prototype SEP (offered by banks, insurance companies, and other financial institutions)
- An individually designed SEP plan document.
The most common document used to secure a SEP IRA for your employees is the 5035-SEP. Be sure to follow all instructions on the form to set up the IRAs for your employees. Note that you cannot use Form 5035-SEP if:
- You maintain any other qualified plan (except another SEP—a plan is “maintained” even if no contributions were made during the year).
- Use the services of leased employees (i.e. employed by a professional employer organization).
- Want a plan for a different calendar year.
- Want an allocation formula that takes into account Social Security contributions you made for your employees.
2. Share SEP IRA With Employees
Next, you’ll need to share all the information about the SEP with all eligible employees—that’s a must. This includes requirements for receiving an allocation, and the basis on which the employer contribution will be allocated. Say you use the 5035-SEP form as the formal agreement for the SEP IRA. You’ll need to provide an additional employee copy of the form and any related instructions that eligible employees should have.
3. Set Up SEP IRA Plans For Each Eligible Employee
Finally, you’ll need to set up the SEP IRA plans for each eligible employee with a bank, insurance company, or other qualified institution. All SEP contributions must go to traditional IRAs. Employees are responsible for making investment decisions about their SEP IRA accounts. In other words, the employee fully owns the SEP IRA—you’ll just contribute to it.
You and your employees will receive a statement from the financial institutions investing your SEP contributions both at the time you make the first SEP contributions and at least once a year after that.
SEP IRA Rules for Employees
SEP plans are governed by the IRS and Department of Labor. There are a variety of rules to comply with when participating in a SEP IRA for employees. Failure to comply with any of these rules could lead to the plan’s disqualification and a tax liability for the employer. Here are some of the most important rules you must follow:
- To be eligible to participate in a SEP IRA, an employee must:
- Be at least 21 years of age
- Has worked for the employer in at least three of the last five years
Received at least $600 in compensation from the employer during the year (for 2018 and 2019)
- Part-time employees and 1099 workers (contractors) are eligible to participate in a SEP IRA.
- An employer can exclude from a SEP IRA:
- Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees’ union and the employer.
- Nonresident alien employees who do not have U.S. wages, salaries, or other personal services compensation from the employee.
- As an employer, you cannot have any other retirement plan for your employees besides another SEP IRA.
- You have to pay a 10% additional tax on the taxable amount you withdraw from your SEP IRA if you are under age 59½ when you withdraw the money unless you qualify for another exception to this tax. In some cases, this tax is increased to 25%.
- If an employee is eligible for a SEP IRA, they must be automatically enrolled unless they decide to forgo an account.
- When an employer makes contributions to a SEP IRA, these contributions must be vested immediately.
- A SEP IRA can be set up at any time prior to the employer’s tax filing deadline.
- Employers can contribute to a SEP IRA anytime before their tax filing deadline and still claim the tax deduction for the prior year.
SEP IRA Use Cases
As we said earlier, a SEP IRA isn’t ideal for every business type. Because the employer must make proportional contributions, SEP IRAs are generally best for very small businesses with less than 10 employees. Furthermore, seasonal businesses can also benefit from SEP IRAs because contributions are discretionary. When business is good, they can defer large amounts, and during the offseason they can forgo contributions. A sales-driven organization might also use a SEP IRA to reward employees for exceeding their revenue goal.
Other applications for a SEP IRA include if you are self-employed and want to contribute more towards retirement than they would be able to with a traditional IRA.
Alternatives to SEP IRAs
If a SEP IRA doesn’t work for your business, you may want to consider a SIMPLE IRA. SIMPLE-IRA plans are also easily established by filling out a form. The forms are either the 5304-SIMPLE, the 5305-SIMPLE, a SIMPLE-IRA prototype, or an individually drafted document. You’ll have to consult a financial advisor to learn more about the forms and to make the right decision for your company.
A SIMPLE-IRA is specifically designated for a company with 100 or fewer employees. Both employees and employers contribute to the IRA. The employer is required to contribute each year, either matching up to 3% of the given employee’s compensation, or a 2% non-elective contribution for each eligible employee. Under the non-elective contribution, the employee must contribute 2% of the eligible employee’s compensation—even if the employee doesn’t contribute to their own SIMPLE-IRA plan that year themselves.
Other facts to know about the SIMPLE-IRA include:
- The employer cannot have another retirement plan for their employees.
- Each employee has 100% ownership over money in a SIMPLE-IRA.
- There is no filing required for the employer.
The major differences between a SEP IRA and a SIMPLE-IRA include:
- A SEP IRA allows for a flexible contribution percentage, while the SIMPLE IRA doesn’t.
- In a SIMPLE IRA, both employer and employee contribute. In a SEP IRA, only the employer contributes.
- The SEP IRA is for a business of any size, while the SIMPLE IRA is for a business with 100 or fewer employees.
The Bottom Line
A SEP IRA is a great retirement plan option for vert small businesses and entrepreneurs who want to save big for retirement. Before setting up a SEP IRA, be sure you understand all the rules and regulations relating to this retirement plan. We also recommend speaking with a tax professional like a CPA to better understand the implications of enrolling your business in a SEP IRA.