The Simplified Employee Pension (SEP or SEP IRA) is a retirement plan that can be established by an employer or a self-employed person. The employer is entitled to a tax deduction for contributions made to the SEP plan and makes contributions to the SEP IRA account of each eligible employee on a discretionary basis. Additionally, under the new legislation of the Establishment of Each Community for Retirement Enhancement Act (SECURE), which was enacted on December 20, 2019, small employers will get a tax credit to offset the costs of starting a 401 (k) plan or an employee savings incentive IRA (SIMPLE) plan with automatic enrollment, in addition to the initial credit they already receive. SEP IRAs typically have higher annual contribution limits than standard IRAs. One of the main benefits it offers to employees is that employer contributions are released immediately.
How Does a Simplified Employee Pension (SEP) Work?
A SEP IRA is an attractive option for many business owners because it does not carry many of the startup and operating costs of most conventional employer-sponsored retirement plans. Many employers also set up a SEP plan to contribute to their own retirement at higher levels than a traditional IRA allows. Small organizations favor SEP plans due to taxpayer eligibility requirements, including a minimum age of 21, at least three years of employment, and a minimum compensation of $ 600. Additionally, a SEP IRA allows employers to skip contributions during years when the business is down. SEP IRAs are treated like traditional IRAs for tax purposes and allow the same investment options. The same rollover and rollover rules that apply to traditional IRAs also apply to SEP IRAs. When an employer makes contributions to SEP IRAs, they receive a tax deduction for the amount contributed. Also, the business is not “locked in” to an annual contribution – decisions about whether to contribute and how much may change each year. The employer is not responsible for making investment decisions. Instead, the IRA trustee determines eligible investments and the individual employee account owners make specific investment decisions. The trustee also deposits contributions, submits annual statements, and submits all required documents to the IRS.
Contributions to Simplified Employee Pension (SEP) IRAs are immediately 100% purchased and the IRA account owner directs the investments. An eligible employee (including the business owner) who participates in their employer’s SEP plan must establish a traditional IRA account to which the employer will deposit SEP contributions. Some financial institutions require that the traditional IRA be labeled a SEP IRA before allowing the account to receive contributions to the SEP. Others will allow contributions to the SEP to be deposited into a traditional IRA regardless of whether the IRA is labeled a SEP IRA.
Contribution Limits for a SEP IRA.
Contributions made by employers cannot exceed the lesser of the following percentages: 25% of an employee’s compensation, or $ 57,000 maximum for 2020 (compared to $ 56,000 in 2019 and $ 55,000 in 2018). As with the traditional IRA, withdrawals from SEP IRAs in retirement are taxed as ordinary income. When a business is sole proprietorship, the employee / owner pays himself the wages and can also make a contribution to the SEP, which is limited to 25% of the wages (or earnings) minus the contribution to the SEP. For a particular contribution rate CR, the reduced rate is CR / (1 + CR); for a contribution rate of 25%. This results in a reduced rate of 20%. Because the funding vehicle for a SEP plan is a traditional IRA, SEP contributions, once deposited, become traditional IRA assets and are subject to many of the traditional IRA rules, including the following:
- Distribution rules
- Investment rules
- Contribution and deduction rules for traditional IRA contributions. They apply to the employee’s regular contributions to the IRA, not to the SEP employer contributions.
- Documentation requirements to establish an IRA account. In addition to the documents required to establish a SEP plan (discussed below), each SEP IRA must meet the documentation requirements for a traditional IRA.
SEP IRA Rules
Not all companies can start SEP IRAs, which were designed primarily to encourage retirement benefits among companies that would not otherwise establish employer-sponsored plans. Sole proprietors, partnerships, and corporations can establish SEPs. The eligible compensation limit for 2020 is $ 285,000 (up from $ 280,000 in 2019 and $ 275,000 in 2018). Unlike qualified retirement plans, where participants, including the business owner, can borrow up to 50% or $ 50,000 of their vested balance, whichever is less; SEP does not have this feature. Additionally, certain types of employees may be excluded by their employer from participation in a SEP IRA, although they would otherwise be eligible based on the plan’s rules.
For example, workers who are covered by a union agreement that negotiates retirement benefits can be excluded. Workers who are nonresident aliens can also be excluded as long as they do not receive US wages or other compensation for services from the employer. SEP contributions and earnings are held in SEP-IRAs and can be withdrawn at any time, subject to the general limitations imposed on traditional IRAs. The withdrawal is taxable in the year it is received. If a participant withdraws before age 59½, an additional 10% tax generally applies. SEP contributions and earnings can be transferred tax-free to other individual retirement accounts and retirement plans. SEP contributions and earnings must eventually be distributed following the minimum distributions required by the IRA.
How are Simplified Employee Pension (SEP) IRAs Taxed?
Employee Simplified Retirement Individual Retirement Accounts are tax-deferred retirement savings plans designed to allow business owners a simpler method of contributing to employee accounts. In essence, a SEP IRA is a collection of traditional IRAs organized under a broad employer plan that allows for employer contributions, something that traditional IRAs cannot offer. There are fairly standard tax benefits for employer contributions, and most of the tax rules for individual accounts are the same as with traditional IRAs.
SEP IRA taxes for employers
Employers can make annual contributions to their employees’ individual accounts as long as they do not exceed the lesser of $ 52,000 (as of 2014) or 25% of the employee’s total annual compensation. A self-employed entrepreneur establishing a SEP IRA must use a special calculation provided by the Internal Revenue Service to determine contribution limits towards his own account. Generally, 100% of all employer contributions are tax deductible for the business. However, if the total contributions exceed 25% of the compensation of all employees, the excess would not be deductible on the business tax return. If a SEP IRA does not meet the plan requirements as set forth in the Internal Revenue Code, the tax benefits for the business will be lost. The only way to avoid the loss of tax privileges is to complete one of the IRS correction programs.
IRA SEP Taxes for Employee Accounts
The tax deferral benefits for an employee’s SEP IRA are similar to traditional IRAs: Contributions to the account are made with earnings before taxes, and all investment growth in the account occurs tax-free. Once a person reaches age 59.5, he or she becomes eligible to withdraw funds from the SEP IRA without incurring a tax penalty. The penalty for early withdrawals is 10%. Once the funds are withdrawn, they are subject to normal income taxes. If they are withdrawn prematurely, a 10% penalty is applied and then income taxes are removed. If a distribution is made for un-reimbursed medical expenses and it exceeds 10% of the person’s adjusted gross income, the distribution is not subject to early withdrawal penalties. Similar exceptions exist for account holders who are left disabled and for those who need to pay for health insurance. Like traditional IRAs and any qualified account with pre-tax contributions, a SEP IRA carries a required minimum taxable withdrawal on an annual basis beginning the tax year after the account holder turns 70. 5. The minimum withdrawal amount is calculated by the IRS based on the year-end account balance and the life expectancy of the account holder. Employees have the option of transferring their SEP IRA funds to another qualified account, such as a regular IRA, without incurring any additional tax penalty.