A SEP IRA stands for Simplified Employer Pension Individual Retirement Account plan. That is some name, and practitioners usually refer to these plans as SEPs for short. This type of plan was created for small business owners and self-employed workers.
These plans were established to allow the small business owner or self-employed worker to set up an easy way to have a retirement plan without all the paperwork and various contribution thresholds found in qualified pension and 401k plans.
Qualified retirement plans are designed for larger employers who have more than 100 employees. The paperwork and accounting requirements for these plans is enough to discourage a small employer from setting up a retirement plan. The SEP solves that problem by making the reporting requirements very simple and not overly burdensome. In fact, normally the custodian you choose for the individual accounts will do the paperwork for you and each covered employee.
How a SEP IRA Works
The SEP works like a grouping of Traditional IRA’s. Each eligible employee opens a SEP IRA for himself at an institution of his choosing. You, as employer put annual contributions into each employee’s account. Your employees make no contributions into the account. Thereafter, the employee has full control over the account, including what investments will be made with the money.
All employees must receive the same percentage of income into their accounts. You cannot give one employee a contribution of 1% of income, and another employee 3% of income. These amounts are always 100% vested, meaning the employees cannot forfeit any amount for any reason.
You also open an account for yourself, as an employee, and make the same contribution percentage into your own account.
You do not have to make the same contribution each year. You can decide at the end of each year how much to contribute to all the accounts, as long as all eligible employees receive the same percentage of income.
All contributions made by you, as the employer, are tax deductible.
Eligible Employees
Employers must include employees if they meet the following 3 requirements:
1. Be 21+ years old
2. Have at least 3 years of service out of the last 5 years
3. Have earned at least $450 in compensation from your employer for the year.
Contribution Limits
For corporations, contributions of up to 25% of compensation can be made in 2011 up to a maximum of $49,000 per employee including you.
If you are a sole proprietor, with no employees, your maximum contribution allowed is 20% of adjusted earned income. Adjusted earned income is determined by completing an IRS worksheet.
When Can You Establish a SEP
You can set up a SEP at any time during the year. Since your contributions are tax deductible, you must make the contributions to the SEP by April 15th if you are an unincorporated sole proprietor. If your company is a corporation or sub-chapter S corporation, you must make the contribution by March 15th.
Withdrawals and Rollovers
The withdrawal rules are the same as under a Traditional IRA. You or your employees can take out money at any time. The withdrawal is taxable as ordinary income to the employee since none of the assets have been taxed yet.
If you make the withdrawal before age 59 ½, an additional 10% penalty is imposed on the amount withdrawn, unless you come under one of the exceptions.
The 10% penalty will not be imposed if it is done due to one of the following reasons:
- Medical Expenses – The penalty won’t be imposed if your uninsured medical expenses are over 7.5% of your adjusted gross income.
- Medical Insurance premiums – If you lose your job at work, receive unemployment payments, and buy medical insurance for your family, the penalty won’t apply.
- Disability – The penalty won not apply if you can’t do any work due to physical or mental problems.
- IRA Beneficiaries – If you should die before 59 1/2, your IRA can be taken out by your beneficiaries without penalty.
- Education Expenses – If you pay the cost of higher education during the year, the withdrawal will not be subject to the 10% tax penalty.
- First Time Homeowner – You can take an early withdrawal from an IRA to purchase, or build your first home. The withdrawals are limited to $10,000.
- Rollover to another Qualified Plan – If your withdrawal is rolled into another qualifying IRA, then it is not subject to the 10% early withdrawal penalty.
- Annuity withdrawals – the penalty won’t apply if your withdrawals are made as part of a series of equal payments. The payments must be made over at least the later of 5 years or age 59 ½.
Investments in a SEP
You can invest in all the same investments as a Traditional IRA. You can purchase:
- Common Stocks
- Bonds
- Mutual Funds
- Savings Accounts
- Certificates of Deposit (CDs)
- Exchange Traded Funds (ETFs)
- Money Market Accounts (MMAs)
- Treasury Inflation Protected Securities (TIPs)
- Real Estate Investment Trusts (REITs)
Investments Not Permitted
You cannot use money in your IRA to invest in either:
- Collectibles
- Cash Value (or Whole) Life Insurance
According to the IRS, Collectibles include:
- Artworks
- Rugs
- Antiques
- Metals
- Gems
- Stamps
- Coins
- Alcoholic beverages
- Certain other tangible personal property
There are a couple of exceptions to the prohibition against Coins and Metals. You can invest in:
- U.S. gold coins, and silver coins minted by the Treasury Department.
- Certain platinum coins and certain gold, silver, palladium, and platinum bullion.
Just Get Started
The SEP is a very simple way to give your employees a retirement plan. It is easy, not complicated with reporting requirements like other plans, and does not commit you long term since you can just not contribute to the accounts if you do not want to. These plans are very cheap to operate. So if you are looking to give your employees a benefit, while also helping yourself save, look into a SEP.