If you’re self-employed or run a small business, you have a lot of decisions in your day-to-day operations. Those who run the show have to keep on top of all aspects of the business. This can include everything from organizing finances to tending to customers and scheduling employees, and more. One of the most important things an employer has to consider is investing for retirement for themselves and their employees. However, not every small business is able to afford a traditional 401k retirement account. If this is a case, some of these organizations may benefit from an investment vehicle known as an SEP IRA.
While any taxpayer who earns income can contribute to an IRA, they still have to abide by the lower contribution limits ($6000 if under 50, $7000 if 50+ in 2020) compared to employer-sponsored plans like a 401k. SEP IRAs offer a fortunate secondary option for employers and employees who need more than an IRA alone can provide.
This article will cover what an SEP IRA is, how they work, and important considerations when selecting a retirement account.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not investment or tax advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment or tax-related decisions.
What Is a SEP IRA?
Unlike a Traditional IRA or Roth IRA (which are strictly individual retirement accounts), Simplified Employee Pension Individual Retirement Arrangement (SEP IRAs) tie to an employer or business. SEP IRA contributions come from the profits of the business; therefore, they qualify as a deduction on the business’s income. Due to this setup, the funds in the account(s) are “pre-tax,” similar to contributions deducted into a traditional IRA.
The maximum contribution permissible into an SEP IRA is typically the lesser of two options: 25% of the employee’s compensation or $57,000 (as of 2020). Notice how that is significantly higher than the contribution maximum for “regular” IRAs. For those who are self-employed, the maximum contribution comes out to roughly 20% of your income or $57,000 in 2020.
It is important to note that contributions made into employee accounts must be uniform across the board. They cannot discriminate in favor of highly-compensated employees, including the business owner.
Like all retirement accounts, the investment growth and income realized within an SEP IRA is tax-deferred until the account owner makes a withdrawal from the account. Withdrawals from SEP IRAs are added to the taxpayer’s income in the tax year in which the withdrawal was made. The withdrawals may also be subject to the 10% early withdrawal penalty if the taxpayer is under age 59 ½ and the withdrawal does not qualify for an exception.
SEP IRAs are also subject to Required Minimum Distribution (RMD) rules just like Traditional IRAs.
What Are The Requirements to Participate in an SEP IRA?
The IRS sets a maximum on how restrictive an employer’s rules can be for an SEP IRA, listed below:
- The employee has reached age 21
- He/She has worked for the employer in at least 3 of the last 5 years
- The employee received at least $600 in compensation from the employer during the year (for 2019 and 2020)
The employer can have less restrictive rules than these if it wishes. There are also a few special circumstances (non-resident alien, union employees, etc) in which some stricter requirements may apply.
What Are the Benefits Of an SEP IRA?
From an employer’s perspective, SEP IRAs are relatively painless to set up and run. All an employer has to do is find a trustee or custodian (usually a financial institution) to set up accounts for each respective employee. From there, the employer is in charge of depositing contributions into the account(s) of the respective employee(s) and the trustee handles the rest of administrative work.
Because SEP IRAs require much less “work” to administer than a full-blown 401k, they are usually relatively inexpensive to run.
Another major benefit of SEP IRAs is the flexibility they offer when it comes to contributions. This may be a big advantage to a newer company that has variable cash flows and may not be able to afford to make contributions to employee accounts. Certain accounts like SIMPLE IRAs and Safe Harbor 401ks require employer contributions.
With SEP IRAs, employees have full control over how the investments are managed. The investments on offer depend on the custodian.
Contributions made into a SEP IRA are always fully and immediately vested to the employee. Some 401k plans come with vesting schedules, meaning that the employee has to be active with the employer for a certain period of time before being able to claim the money deposited by the employer. The relaxed rules of an SEP IRA can be a big plus for employees.
What Are Some Limitations Of SEP IRAs?
While SEPs are simple to set up and administer, they do not come with some of the features offered by other full-blown employer-sponsored retirement accounts.
For instance, unlike a 401k, an SEP IRA does not allow for loans from the balance. As discussed earlier, any distribution made from the account is subject to ordinary income tax and a potential 10% early withdrawal penalty if the taxpayer is under age 59 ½. Moreover, SEP IRAs do not offer “catch-up” provisions for employees that are age 50 or older.
SEP IRAs also do not allow for employee contributions. This may be a drawback for employees that want to add pre-tax contributions into their employer’s account. The employee would have to contribute to their own, separate IRA if they wanted to make individual contributions.
Furthermore, SEP IRAs do not offer after-tax or Roth contribution options. This is due to the fact that the contributions come from the business’s income. The internal revenue code does not allow for such a double-dip.
From an employer’s perspective, the contributions made to employee SEP IRA accounts cannot be “forfeited”, since there is no vesting schedule that applies to SEPs. Another thing to consider is that if an employee was eligible to receive a SEP IRA contribution, they must receive it, even if they terminate employment prior to the end of the calendar year.
Because SEP IRA contributions cannot be discriminatory, every single employee must receive the same contribution in terms of percentage relative to their salary. As the owner, if you contribute 15% of your income to your SEP account, every single employee must also receive a contribution that is equal to 15% of their salary. This can be costly for a business that is looking to expand and scale its operations.
What Can Employees Do With The Account After Separating?
Even though SEP IRAs are linked to an employer, and offer higher contribution limits, they still function like regular IRAs for all intents and purposes. This includes instances such as when an employee leaves a company’s payroll.
If an employee separates from employment, they have several options, such as:
- Leaving the assets where they are
- Rolling the funds into their own IRA
- Rolling the funds into another employer-sponsored plan
- Taking a full distribution of the account value
- Taxes and penalties may apply
Based off of those options, the employee should do what they believe is in their best interest. Each option comes with its own pros and cons. It’s always wise to consult an investment professional or tax professional with questions about your personal situation.
Does a SEP IRA Make Sense For My Business?
If your business is in a place where you can afford to start providing retirement savings benefits to your employees and/or yourself, you should give careful consideration to what vehicle you choose. SEP IRAs can be a great option if you:
- Want to keep administrative costs low
- Like the simplicity of administration and recordkeeping
- Like flexibility when it comes to employer contributions
- Want higher contribution limits
SEP IRAs may be less attractive if your business is larger. Making an equal contribution from the business’s profits across all eligible employees may not always be viable for the longevity and scalability of the business.
The decision that you go with when picking a retirement savings vehicle for your business should take into account:
- Predictability of the company’s cash flows
- Business strategy and goals
- Needs and desires of employees that you are wanting to retain
It is also not uncommon for small businesses to start with small business retirement plans like SEP IRAs or SIMPLE IRAs and later graduate to 401ks.
Whatever the circumstances of your small business, do your best to go with whatever makes the most sense for the time being. As your business expands, you will be able to expand the offerings and benefits that you extend to your employees.
Looking for more information on retirement accounts? Check out our article on 401(k)s vs Roth IRAs.
Have questions on SEP IRAs? Let us know!