SEP IRAs- A Low Cost Retirement Plan for Small Businesses

© Denise Appleby, CISP, CRC, CRPS, CRSP, APA

The simplified employee pension plans (SEP)s is one of the most popular  employer sponsored retirement plans among small business owners . This is due, in part, to the fact that very little administration is required to maintain the plan. However, before choosing a SEP plan for it’s business, the employer should consider all the features and how they fit into the business’ profile.

Eligibility

Employees

Let’s start by looking at employees who must be covered under a SEP plan. For eligibility purposes, the term employee includes the business owner.

When establishing a SEP plan, the employer can choose to include all employees, or only those who meet certain requirements. When excluding employees, the limitations must be within guidelines as defined by the tax Code, so as to prevent non-compliant issues. The following is the list of employees who must receive the applicable portion of any contributions to the employer’s SEP plan for the year.

• Employees who performed services with the employer for at least three of the five preceding years. For instance, if a contribution is being made for 2008, an employee who worked for any three of the following years has satisfied this requirement: - 2007, 2006, 2005, 2004 and 2003.
• Employees who earned at least $500 for the year
• Employees are who at least age 21
• Employees who are not part of a collective bargaining agreement ( union employees whose retirement benefits were determined under a collective bargaining agreement)
• Employees who are not nonresident aliens with no US income

Of course, the employer can make the requirement less strict. For instance, the years of eligibility service requirement could be one or two years, instead of three-years. The employer may even allow all employees to participate, regardless of their service, age, compensation, or union coverage.

Note: A common mistake is to improperly define years of service for SEP IRAs. For qualified plans, a year of service can be defined as up to 1,000 hours of service during the year. This is not the case for a SEP IRA- as any service during the year -regardless of how short, is counted as one year. For instance, if the employee worked one day during that year, that is treated as one year of service for eligibility purposes.

When selecting these requirements, the business owner should check to make sure they will not result in him/her being excluded from the plan. For instance, if he/she is under age 21, then selecting age 21 as the age eligibility requirement will result in him/her being excluded from the plan.

Businesses (Employers)

SEP IRAs can be established by any business entity. This includes sole proprietorships, partnerships and corporations.

Establishing The SEP IRA

Establishing the Plan

In order to establish a SEP IRA, the employer must complete a SEP Adoption agreement. This can be the IRS model Form 5305-SEP or 5305-A SEP Adoption agreement, the financial institution’s Prototype SEP agreement, or the employer’s own individually designed SEP adoption agreement.  Most financial institutions will provide the employer with the SEP adoption agreement, including copies of the IRS model documents. Employers should check with the financial institution to find out their requirements, including whether they have any restrictions. For instance, some financial institutions will not use the IRS Form 5305-A SEP, which is the version that allows for salary deferrals. Most however, will accept the IRS Form 5305-SEP

When Not to Use the IRS Model 5305-SEP

Tthe IRS Model 5305-SEP cannot be used If any of the following applies to the business:

• The employer maintains any other retirement plan for the business
• IRAs have not been established for employees who are eligible to participate in the SEP
• The employer uses the services of leased employees
• The business is a member of a controlled group or affiliated service group
• Salary (elective) deferral contributions will be made to the SEP. Note: Salary deferral SEPs (SARSEPS) cannot be established after December 31, 1996. However, SARSEPs that were established by December 31, 1996 are grandfathered. SARSEPs are beyond the scope of this article

The employer may instead use the financial institutions Prototype SEP IRA Adoption agreement or an individually designed SEP IRA adoption agreement.

Adoption and Employee-Notification

Once the employer decides on the SEP adoption agreement, the next steps are

• Completing the SEP IRA adoption agreement
• Notifying employees that the SEP IRA has been established, and
• Informing employees of the eligibility requirements. For 5305-SEPs, the notification requirement is satisfied by providing eligible employees with a copy of the completed form. For prototype SEPs, a special document- such as a summary plan description, should be included in the SEP kit and must be provided to all employees.  The prototype SEP IRA kit should be consulted, so as to identify the documentation that should be used to satisfy the employee-notification requirement

Employee IRAs

Each eligible employee must establish a traditional IRA to receive SEP IRA contributions. Some financial institutions require a copy of the SEP IRA adoption agreement, and may need to flag the account as a SEP-IRA in order to allow SEP IRA contributions to be made to the account. This includes including ‘SEP IRA’ in the account registration.

Deadlines

SEP IRAs must be established by the employer’s tax filing deadline, including extensions

Contributions

Contributions for an employee can be up to 25% of the employee’s eligible compensation, providing the contribution amount does not exceed $46,000. For SEP IRAs, the compensation cap applies, which means that no more than $230,000 in compensation can be taken into consideration for purposes of determining SEP contributions for an employee.

*Note: For unincorporated business owners, the contribution is the lesser of 20% of the modified net profit or $46,000 ($45,000 for 2007).

Contribution Formulas

The employer may choose one of three contribution formulas, when making SEP contributions. These are as follows:

• A pro-rata formula, , where each eligible participant receives the same percentage of their eligible compensation as contributions.
• A flat dollar formula, where each eligible participant receives the same dollar amount as contributions. This option is available only if allowed under the SEP adoption agreement.
• A social security integration formula, where employees who receive contributions in excess of the taxable wage base receive a higher percentage of contributions than other employees. This option is available only if allowed under the SEP adoption agreement.

Deductibility

An employer may deduct up to 25% of the aggregate compensation paid to all eligible employees. The compensation cap applies here as well.

Deadline

Contributions must be made to employees SEP IRAs by the employers’ tax filing deadline, including extensions

Distributions

Since the funding vehicle for SEP contributions is a traditional IRA, the traditional IRA distribution rules apply. This means that employees may distribute their assets at anytime.

Amounts distributed from a SEP IRA are treated as ordinary income.

Early Distributions

Distributions that occur before the IRA owner reaches age 59 ½ are subject to an excise tax of 10%, unless the individual qualifies for an exception to this penalty. The list of exceptions includes the following:

• The distributions are not more than the individual’s  unreimbursed medical expenses that exceed 7.5% of the individual's adjusted gross income (AGI).
• The distributions do not exceed the cost of the individual’s  medical insurance.
• The distributions occur while the individual was disabled. ( disability for this purpose is defined under the Internal Revenue Code (IRC) /Tax Code)
• The distributions occur from a traditional IRA that the individual inherited from someone other than his/her spouse, or if the person was his/her spouse, he/she elected not to treat the IRA as his/her ‘own’
• The distributions are part of a substantially equal periodic payment (SEPP)/72(t)
• The distribution amounts do not exceed the individual’s  qualified higher education expenses.
• The distribution amounts were used to buy, build, or rebuild a first home( limit of $10,000).
• The distribution is as a result on an IRS levy of the IRA

Required Minimum Distribution

In most cases, distributions from a SEP IRA are optional. However, this changes when the account owner reaches age 70 ½, as he/she must begin taking annual required (RMD) minimum distributions for the year he/she reaches age 70 ½.

The SEP IRA custodian is responsible for calculating the RMD amount, providing the SEP IRA was held with them as of the end of the previous year.

Highlights of Benefits and Drawbacks

The following table includes a summary of the benefits and drawbacks of adopting a SEP IRA, instead of another retirement plan- such as a qualified plan, for the business