SEP IRA: Ultimate Guide to Simplified Employee Pension Plans

A SEP IRA, or simplified employee pension plan, can allow small business owners to contribute up to $69,000 per year to a tax-sheltered retirement plan.

I learned a good deal about this plan in my own search for a self-employed retirement plan. A SEP IRA may not be the right plan if you have employees, because you must match contributions to their plans with your own contribution.

Let’s take a deep dive into the SEP IRA to help you decide if this is the right retirement plan for you

What is a SEP IRA?

We can think of a SEP IRA as a traditional IRA on steroids. That’s because it provides a much larger annual contribution amount, enabling you to build up a large retirement investment portfolio quickly.

But even with the higher contributions, you can set up a SEP IRA with a financial institution of your choice, and manage your own investments.

SEP IRAs are designed primarily for small businesses, and especially for sole proprietorships.

They give small businesses many of the same retirement benefits as large employers offering 401(k) plans.

How does a SEP IRA work?

The SEP IRA is a qualified retirement plan created to give small businesses and sole proprietors an opportunity to get many of the same benefits available through employer-sponsored retirement plans.

That includes much larger contributions than what are available with traditional IRAs.

For example, the maximum contribution to a SEP IRA (which will be covered in detail in the next section) is $69,000. That’s comparable to the maximum contribution on the 401(k) plan.

Taxpayers can deduct up to 25% of their compensation, as long as it doesn’t exceed the maximum dollar amount.

While SEP IRAs are designed specifically for small businesses, they are available for businesses of any size. There are no specific requirements, other than that, the business – and any individuals employed by it – must have a positive income.

SEP IRAs can be set up with the financial institution of your choice, whether that’s a bank, and investment broker, or insurance company.

And unlike most 401(k) plans, a SEP IRA can be a totally self-directed account with a nearly unlimited number of investment options.

Contributions to a SEP IRA are deductible from taxable income in the year they are made. Distributions, if taken after age 59 ½, are subject to ordinary income tax.

Like most other defined contribution retirement plans, SEP IRAs are subject to required minimum distributions (RMDs), beginning at age 73.

SEP IRA Contribution Limits

One of the advantages of a SEP IRA is the very generous contribution limits the plan provides. 

Be aware that $69,000 is the absolute maximum, since SEP IRAs are not eligible for catch-up contributions for taxpayers aged 50 and older, the way other retirement plans are.

In addition, contributions are not permitted on total compensation in excess of $345,000.

Let’s work an example based on 25% of compensation. As you’re about to see, 25% isn’t exactly 25% in the way things work with the IRS.

Let’s say you have compensation of $100,000 from your business. Now if you were to make a contribution equal to 25%, you would contribute $25,000 – but that’s not quite how it works.

The IRS first requires that you deduct the dollar amount of the contribution to the SEP IRA before applying to the 25% limit. Translated, this means the real contribution limit is 20%, not 25%.

Carrying our example forward, your actual contribution would be $20,000, not $25,000. The calculation looks like this:

$100,000 compensation – less the $20,000 contribution = $80,000 X 25% = $20,000.

Yes, it looks more complicated than it needs to be, but that’s how it works. For simplicity sake, you should assume your actual contribution rate will be 20% of compensation.

If you’re not already confused, there’s an additional income limitation.

If you are self-employed, you must deduct one-half of your self-employment tax from your compensation – as well as the dollar amount of your contribution – before calculating the contribution amount.

Confused? There’s no need to be – there are competent CPAs and excellent tax software programs that will perform this calculation for you.

Now let’s take an example where your compensation is $400,000. 20% of $400,000 is $80,000 – but we know the maximum contribution is limited to $69,000.

For practical purposes, the IRS limit on compensation is $345,000. At 20%, the contribution on that compensation level will be exactly $69,000. If you earn more than $345,000, no additional contribution is permitted.

Contributions made to a SEP IRA must be completed by April 15 following the just completed income tax year. As an IRA account, there is no contribution extension should you submit an extension to file your return.

SEP IRA Rules: Who is eligible?

SEP IRAs are designed specifically for small businesses, and especially for sole proprietorships. They work like ordinary IRAs, but offer much larger contribution amounts.

Plans can also be extended to include employees. Each participant in a SEP IRA must meet the following requirements:

• Be at least 21 years old
• have worked for the employer in at least three of the past five years, and
• has received at least $750 in compensation.

Employers can impose less restrictive requirements, but they cannot impose more restrictive ones.

Employers are also able to exclude employees covered by union agreements with retirement benefits that are bargained for in good faith by the employees union and the employer, or non-resident aliens who do not have U.S. wages, salaries, or other personal services compensation from the employer.

Contributions to a SEP IRA must be made for employees by the employer.

In addition, a separate IRA account must be set up for each individual employee who participates in the plan.

Pros & Cons

Like virtually every other retirement plan available, SEP IRAs have both benefits and disadvantages that must be carefully evaluated before establishing a plan.

Solo 401(k) vs. SEP IRA

Another popular retirement plan for small businesses is the solo 401(k). It’s a 401(k) plan set up for a sole proprietor and his or her spouse.

However, additional employees can be added later, but the plan will then convert to a traditional 401(k). The solo 401(k) and the SEP IRA have much in common:

Feature	Solo 401(k)	SEP IRA
Maximum contribution	$69,000*	$69,000
Investment options	Unlimited	Unlimited
Required minimum distributions	Yes	Yes
Roth provision	Yes	Yes
Loans permitted	Yes	No
Available to employees?	Yes, but then it becomes a traditional 401(k)	Yes, and employer must make all contributions on behalf of the employee

SEP IRA vs. SIMPLE IRA

A SIMPLE IRA is another type of IRA that sits somewhere between a traditional IRA and a SEP IRA. It allows for higher contributions than a traditional IRA, but much lower than a SEP.

In most other respects, SIMPLE and SEP IRAs work much the same way.

Feature	SIMPLE IRA	SEP IRA
Maximum contribution	$16,000, plus $3,500 if you are 50 or older	$69,000
Investment options	Unlimited	Unlimited
Required minimum distributions	Yes	Yes
Roth provision	Yes	Yes
Loans permitted	No	No
Available to employees?	Yes, and requires employer matching contributions	Yes, and employer must make all contributions on behalf of the employee

How do I set up a SEP IRA plan?

One of the advantages of a SEP IRA is that they are generally easy to establish. You should start by choosing the investment broker, bank, or insurance company that will act as trustee for the plan.

Larger ones have departments that offer assistance with establishing SEP IRAs that can make the process much easier.

Establishing a SEP IRA can be done in three steps:

1. Execute a written agreement to provide benefits to all eligible employees.

This step will be necessary if you have employees who will participate in the plan but are not required for sole proprietorship.

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

2. Provide employees with certain information about the written agreement.

IRS Form 5305-SEP can be used as a guideline for most plans, though the contribution income limits in the form are badly outdated since it has not been updated since 2004.

That means you really can’t use it, but you can use it as a model for your written agreement. You must also provide employees with:

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

A copy of the completed written agreement (or IRS Form 5305-SEP) must be given to each employee, along with the following information:

• A statement that IRAs, other than the one the employer contributes , may provide different rates of return, and contain different terms.
• 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.
• 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.

3. Set up a SEP IRA account for each employee.

This can be done through the same financial institution that acts as trustee for the employer’s SEP IRA, however, all contributions must go to traditional IRAs for participating employees.

Each employee is responsible for making investment decisions within his or her respective account.

All fees and commissions charged by the trustee must provide a “plain language explanation”, especially those imposed on any assets withdrawn before the expiration of a specified period of time.

Is a Simplified Employee Pension a good idea?

Whether or not you should open a SEP IRA really depends on your income level. If your business provides compensation that’s well above $35,000, a SEP IRA will allow for much larger contributions – and tax deductions – than a traditional IRA.

For example, if you earn $100,000, you can contribute $20,000 per year with a SEP IRA, versus only $7,000 per year with a traditional IRA.

In spite of the much larger contribution amount, a SEP IRA works much the same as a traditional IRA. You can open an account with a broker of your choice, then choose and manage all investments. It’s a perfect strategy to rapidly build a large retirement nest egg, while having complete control over the investing activities.

If you want to open a SEP IRA, contact an investment broker that offers these plans. They can help you set up and manage your plan going forward.

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