Designed as a way for small business owners and self-employed individuals to contribute to their own and their employees’ retirement savings, a Simplified Employee Pension (SEP) plan helps employers to make tax-deductible contributions to a traditional Individual Retirement Account (IRA) set up for eligible employees.
The plan provides a simplified and more flexible approach to saving for retirement with minimal administrative costs incurred.
How a SEP Works
Because of their flexibility, SEPs can be particularly advantageous to employers that operate in cyclical industries, which see varying levels of income over different periods in the year. This allows businesses to make larger contributions to employees during busier periods while lowering their payments during quieter times.
Using the right SEP provider allows employees to choose the type of investment fund that suits their risk appetite the best.
Opening a Simplified Employee Pension means setting up a SEP plan, which often involves using IRS Form 5305-SEP. This form is kept for business records and is not filed with the IRS.
Employers will then open a separate SEP-IRA at a financial institution for each of their eligible employees. It’s the responsibility of the employer to decide the contribution percentage each year, and this figure must be uniform for all eligible employees.
The employer must cover all eligible employees with the plan who are aged at least 21 years old, have worked for the company for at least three of the past five years, and earned at least $750 in compensation over the tax year.
Anatomy of a SEP
Simplified Employee Pensions receive employer contributions only. Unlike other retirement plans, this means that the employee isn’t obligated to pay into their SEP-IRA.
This form of pension also comes with tax advantages on employer payments, and all contributions are tax-deductible for the business, with any earnings allowed to grow tax-deferred until an employee reaches retirement.
With high contribution limits of up to 25% of an employee’s compensation, or a maximum of $70,000, depending on whichever is less, employers can make substantial payments to their SEP-IRA. For self-employed individuals, this limit is capped at 20% of net earnings.
Crucially, employers aren’t obliged to contribute every year and have the freedom to decide each year whether to contribute and how much to add to the SEP-IRA. This means that SEPs provide a great level of flexibility for businesses with fluctuating profits.
Once an employer makes a contribution, the money will be immediately vested, meaning that employees gain 100% ownership of the money in their SEP-IRA straight away.
SEP Advantages
There are many advantages for employers taking out a Simplified Employee Pension plan, particularly when it comes to small businesses in seasonal industries. These benefits include:
- Simplified contribution plans and lower administrative costs
- Flexible contributions that can be adjusted or suspended depending on the business environment
- Higher limits offer significant tax-deductible savings, particularly for self-employed workers
SEP Disadvantages
However, SEP plans can also come with disadvantages for employers and employees based on their circumstances, and these drawbacks include:
- Lack of employee contributions can be limiting for retirement savings
- Because SEPs are mandatory for all eligible employees, the same percentage for all rules can be costly for larger employers
- Without catch-up contributions, employees closer to retirement could lose out on boosting their retirement pot with an SEP-IRA.
FAQs
Employer contributions must be made by the due date for filing federal income tax returns for the year. Contributions can be deducted, and employees are able to exclude SEP contributions from their gross income.
SEP contributions and earnings are held in SEP-IRAs and can be withdrawn at any time, subject to the limitations imposed on IRAs. If an employee makes a withdrawal before they are aged 59½, they’re likely to be subject to an additional 10% tax.