Consider a Simplified Employee Pension (SEP IRA) Plan for Your Small Business

SEP IRA benefits

Contribution flexibility

When it comes to SEP IRA benefits, the biggest ones for small business owners are typically flexibility and ease. With this option, you can contribute as much as you choose (subject to IRS limits) whenever you want. Contributions need to be made by the tax deadline of that year and must be equal as a percentage of compensation across the entire employee pool.

This means the business owner can delay making a decision on how much to contribute for the tax year in question until the filing deadline the following year. Since the amount is not guaranteed from year to year, employers can increase or decrease their contributions with the ebb and flow of business revenue.

Administration ease and affordability

SEP IRA plans require very little administrative effort. Other types of retirement plans, such as a 401(k), require non-discrimination testing on an annual basis and will need to have a 5500 tax filing prepared annually. This type of tax filing typically places a great deal of reporting risk on the preparer and can therefore cost thousands of dollars every year.

Another administrative SEP IRA benefit is the lack of required annual employee notices. 401(k) plans often require documents such as Safe Harbor Notifications to be delivered to each employee by a precise due date each year. With SEP IRA plans, employers generally face no annual filing requirements.

Employers are, however, required to provide certain notices to employees, including:

  • A copy of Form 5305-SEP and the other documents and disclosures listed in the Form’s instructions
  • Notice of any amendments to the SEP and changes to the requirements for receiving contributions
  • An annual contribution statement

At Guideline, we handle all of this paperwork for you.

Higher contribution limits

Typically, the No. 1 reason a business owner will choose a SEP IRA over a traditional or Roth IRA is the higher contribution limits of SEP plans. For years 2019-2021, individuals cannot have more than $6,000 ($7,000 if over the age of 50) contributed to their traditional or Roth IRA. With a SEP account, however, the limit is up to the smaller amount of either 25% of a person’s annual compensation or $58,000 (as of 2021). This is increasing to $61,000 in 2022.

As an additional bonus, a person is allowed to max out both a SEP IRA and a traditional or Roth IRA within the same year. So in 2021, if you are a small employer with a SEP plan, you can contribute the full $58,000 (if your compensation is at least $232,000) and also max out your traditional or Roth IRA. This means you can put away up to $64,000 or $65,000 each year toward retirement as opposed to $6,000-7,000 with an IRA alone.

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Investing Through SEP IRAs

When you set up your SEP IRA and put funds into it, you can invest the money. SEP IRAs follow the same investment rules as a traditional IRA. For example, this means you:
  • Can’t invest your money in collectibles, such as artwork or antiques
  • May not be able to invest your money in real estate
  • Shouldn’t report losses and gains on your tax returns if your account is still open
Your investment options can depend on your:
  • Age
  • Planned retirement age
  • Risk tolerance
You can visit the IRS website to learn more about For example, if you’re younger, you may be more willing to take on a risk by investing in stocks. But, if you’re closer to retiring, you may want to put your investments in bonds.You can visit the IRS website to learn more about IRA investment rules.

The SECURE Act and Small Businesses

In December of 2019, former President Donald Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which is designed to improve retirement security for many Americans.

Under the Act, small business employers will receive a tax credit for automatically enrolling workers into their retirement plans. Under the SECURE Act, small employers will get a tax credit to offset the costs of starting a 401(k) plan or SIMPLE IRA plan with auto-enrollment in addition to the start-up credit they already receive.

The bill also widens access to multiple employer plans for small businesses because employers no longer have to share “a common characteristic,” such as being in the same industry. Also, employer-sponsored retirement plans will be available to part-time workers who are eligible after one full year with 1,000 hours worked or three consecutive years with a minimum of 500 hours worked.

SEP IRA vs. a 401(k) vs. a Roth IRA

The SEP IRA is a popular retirement account, and those who have the option for a SEP IRA may also be considering a 401(k) or a Roth IRA account. Here are some of the key differences,

  • A SEP IRA is available only if your employer offers it, and in some cases, the employer may be you. If you’re a single freelancer, the account allows you to stash as much as 25 percent of your company’s earnings to your account tax-deferred, up to an annual maximum of $61,000. The account’s distribution rules are like those of a traditional IRA.
  • A 401(k) is an employer-sponsored retirement plan that lets you save money on a tax-deferred or tax-free basis. Employees can save up to $20,500 (in 2022), and employers may add matching funds into the account as well. The account comes in two major varieties: the (pretax) traditional 401(k) or the (after-tax) Roth 401(k).
  • A Roth IRA allows anyone with earned income (or even spouses of those with earned income) to contribute. Contributions are made with after-tax money, and you’ll be able to grow the account tax-free and then withdraw your money tax-free in retirement. Annual contributions are limited to $6,000 (in 2022).

The good news is that you can contribute to all these plans. However, your maximum contribution to the SEP IRA and the 401(k) together is $61,000, including both employer and employee contributions. You can max out your employee contribution in the 401(k) at your day job, and then still add money to your SEP IRA, until you hit the annual maximum.

And regardless of how much you contribute to either a 401(k) or a SEP IRA, you’re still able to contribute to a Roth IRA (or a traditional IRA), up to the annual maximum.

How to invest with a SEP IRA

Remember: your SEP IRA is a type of retirement account, not an actual investment. As with any investment account, how aggressively you invest and the types of assets you buy depends on your age, the age at which you plan to retire and your risk tolerance. Carefully consider your own future needs as you choose investments for your portfolio.

In general, asset allocation models suggest that you weight your retirement portfolio toward stocks while you’re young and further away from retirement. As you move closer to your retirement date, many experts suggest reducing the risk of your portfolio and boosting its income component by rebalancing it to include more bonds. The reason? Stocks historically have generated bigger returns over the long-term than fixed income assets, but suffer more price volatility in the short-term.

Your account provider should have a variety of stocks, bonds and mutual funds to choose from. Each of your employees should have their own accounts with the provider so they can choose their own investments and asset allocation.

Disadvantages of a SEP IRA

From an employer's viewpoint, there are definite disadvantages of SEP IRAs.

Immediate Vesting

To reduce employee turnover and the cost associated with training new employees, some employers want their workers to be employed for several years before they are vested in the employer contributions. For SEP IRAs, however, contributions are immediately 100% vested, which means that future vesting is not a tool to lower employee turnover. As soon as they are deposited, the contributions belong to the employee.

No Loans Permitted

Unlike qualified plans—under which participants, including the business owner, may borrow up to the lesser of 50% or $50,000 of their vested balance—the SEP, like all IRA-based plans, does not have this feature.

Employee Eligibility Requirements

For a SEP IRA, a year of service is any period, however short. This can result in increased expenses associated with funding the plan, which may be a disadvantage, particularly for businesses that hire part-time or seasonal employees.

What Are the Requirements of a SEP IRA?

Generally, the following requirements must be met:

  • Set up by any employer — including a sole proprietorship, partnership, corporation, or nonprofit organization – with one or more employees.
  • Participants must be at least the age of 21.
  • Include all employees who have performed services for the employer for three of the preceding five years
  • Employers have the option to offer the plan to more people, for example, all employees with at least one year of service.
  • Received at least $600 in compensation from the employer during the year, for example, 2018 and 2019.

Establish a SEP Plan

The first action you’ll need to take is to choose a financial institution to serve as trustee of the SEP-IRAs that will hold each employee’s retirement plan assets. These accounts will receive the contributions you make to the plan.

Set-up steps for a SEP

There are three steps to establishing a SEP.

  1. Execute a written agreement to provide benefits to all eligible employees.
  2. Give employees certain information about the agreement.
  3. Set up an IRA account for each employee.

Written agreement

The written agreement must include the name of the employer, the requirements for employee participation, the signature of a responsible official and a definite allocation formula.

The IRS has a model SEP plan document, Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution AgreementPDF. Do not file this form with the IRS.

You may not use Form 5305 – 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,
  • Want a plan year other than the calendar year, or
  • Want an allocation formula that takes into account Social Security contributions you made for your employees.

If you can’t use the Form 5305-SEP, you may use a prototype document. A mutual fund, insurance company, bank or other qualified institution usually provides these. You may also have a SEP individually designed for your business.

Provide information to participants

You must furnish your eligible employees:

  • Notice that you have adopted the SEP
  • Requirements for receiving an allocation
  • The basis on which the employer contribution will be allocated

If you use Form 5305-SEP, you must give your employees a copy of the form and its instructions. The model SEP is not considered adopted until each employee is provided with the following information:

  1. A statement that IRAs other than the one the employer contributes to may provide different rates of return and contain different terms.
  2. A statement that the administrator of the SEP will provide a copy of any amendments within 30 days of the effective date along with a written explanation of its effects.
  3. The administrator will give written notification to the participant of any employer contributions made to a participant’s IRA by January 31 of the following year.

If you use a prototype or individually designed plan you must give all eligible employees similar information.

Set up a SEP-IRA for each employee

A SEP-IRA must be set up by or for each eligible employee. They may be set up with banks, insurance companies or other qualified financial institutions. All SEP contributions must go to traditional IRAs. Employees are responsible for making investment decisions about their SEP-IRA accounts.

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. Each institution must provide a plain-language explanation of any fees and commissions it imposes on SEP assets withdrawn before the expiration of a specified period of time.

Timing of setting up a SEP plan

You can set up a SEP for a year as late as the due date (including extensions) of your business income tax return for the year you want to establish the plan.

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Setting up a SEP IRA

As an employer, opening a SEP IRA is very simple. First, you need to choose a plan provider. When you contact a plan provider, they will ask you to complete your plan setup by filing paperwork online, by mail, or in person. After you’ve finished setting up a SEP IRA, you will need to alert all eligible employees. Once your employees set up their accounts, you’ll be ready to start making contributions.

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Tax-Deductible Contributions

As a small business owner you can deduct your contributions for yourself and your employees from your company’s federal taxable income. The individual traditional IRA contribution if made – may or may not be deductible depending on individual tax filing status and modified adjusted gross income.

Game Plan

For details on establishing a SEP, along with rules on participation, compensation, contributions, distributions, and more, review these SEP plan FAQs from the IRS.

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