Business owners: How to set up a SEP IRA
If you want to establish a retirement plan for your business and you missed the last deadline to establish a qualified plan, you may want to consider establishing an SEP. While qualified plans must be established by the end of the plan year (December 31 for plans maintained on a calendar year), SEPs may be established by the business's tax-filing deadline, including extensions. This plan also offers many other attractive features. Here, we review some of these features as well as some factors that you may want to consider before choosing it for your business.
Employer eligibility and suitability
An SEP is ideally suited for small businesses and may be established by any business owner, including sole-proprietorships, corporations and partnerships. The SEP is attractive to small businesses because it is easy to establish and administer.
An employer may decide each year whether to contribute to the SEP. This is an attractive feature for a new business that has not established a trend in its annual earnings. Because of this flexibility, the employer could decide to forgo the SEP contribution in years when profits are less than anticipated.
As with many other employer plans, the employer has up to the tax-filing deadline of the business, including extensions, to fund the SEP IRA. Individual employees may use their traditional IRAs to receive their SEP and Traditional IRA contributions.
Deducting SEP contributions
An employer may deduct up to 25% of eligible compensation paid to employees for the year. For each employee, the maximum amount of compensation that may be considered for 2019 is $280,000 ($285,000 in 2020). The type of business determines the type of form the employer uses to claim the deduction for SEP contributions.
- A sole proprietor claims the SEP contribution on behalf of himself/herself on IRS Form 1040; however, SEP contributions on behalf of the sole proprietor's common-law employees are claimed on Schedule C.
- Partners in a partnership claim deductions for their individual SEP contributions on IRS Form 1040. For contributions made on behalf of common-law employees, the partnership claims the deduction on IRS Form 1065.
- For an S-corporation, all SEP contributions are claimed on IRS Form 1120S.
- For a C-corporation, all SEP contributions are claimed on IRS Form 1120-A.
Business owners should consult with their tax professionals to ensure the proper forms are filed to report and claim the deduction for SEP contributions.
Deducting plan expenses
A business owner may be eligible to receive a tax credit for expenses incurred when establishing the SEP. The business owner may also be able to deduct plan expenses, including contributions made to the plan.
An employer may exclude the following categories of employees from participating in the SEP for the year:
- Employees covered under a collective bargaining agreement (unionized employees)
- Employees who are under age 21
- Employees who earn less than $600 (indexed for inflation) for the year (2018 and 2019)
- Employees who worked less than three of the five preceding years
- Non-resident aliens with no U.S. income
Under ABC Inc.'s SEP IRA, an individual must work three of the five preceding years in order to be eligible to receive an SEP contribution for the year. Jane worked for ABC Inc. on a part-time basis in 2016, 2017, 2018, and 2019. Assuming Jane meets the other eligibility requirements, she is eligible to receive a contribution for 2020, because she worked for at least three of the five years preceding 2020. For SEP IRAs, a year of service can be any period, however short. This means that an employee who worked for one week in a year is counted as having completed a year of service.
The employer may choose to use less restrictive eligibility requirements in order to allow more employees to participate in the plan.
Small business owners find the SEP IRA attractive because of its minimal administrative requirements. Unlike qualified plans, the SEP does not require non-discrimination testing or filing of 5500 returns. Establishing an SEP IRA can be as easy as completing IRS Form 5305-SEP and providing a copy to employees.
SEP contributions are made to the separate IRAs for eligible employees. Each employee is responsible for establishing his or her own Traditional IRA to receive employer contributions. Unlike employers with qualified plans, the employer of an SEP has no responsibility for providing assistance with investing plan contributions. Individual participants may select their own IRA provider and direct their investments.
For the employer, tax reporting is limited to reporting SEP contributions on the business' tax return. For individual participants, the IRA custodian or trustee reports SEP IRA contributions on IRS Form 5498 and distributions on IRS Form 1099-R. Employers and employees should bear in mind that the custodians report contributions in the year they are received. For instance, if ABC Inc. makes its SEP contributions for 2019 in May of 2020, the Form 5498 may not correspond with the amount the employer reports for 2019. Employers should therefore maintain their own records to keep track of SEP contributions.
Disadvantages of a SEP IRA
To reduce employee turnover and the cost associated with training new employees, some employers like to have employees work for a number of years before the employee is vested in the employer contributions. For SEP IRAs, however, contributions are immediately 100% vested, which means the employee may withdraw the amount immediately after it is deposited into his/her SEP IRA.
No Loans Permitted
Unlike qualified plans - under which participants, including the business owner, may borrow up to the lesser of 50% or $50,000 of their vested balance - the SEP, like all IRA-based plans, does not have this feature.
Employee Eligibility Requirements
Under a qualified plan, an employer may require an employee to work at least 1,000 hours in order to accrue one year of service. For an SEP IRA, a year of service is any period, however short. This can result in increased expenses associated with funding the plan, posing a disadvantage especially for businesses that hire part-time or seasonal employees.
Like many small business owners, you may enjoy the simplicity and inexpensive administration of the SEP IRA. While it may be convenient to establish the SEP, you should consult your tax professional to ensure that the plan you choose is suitable for your business profile. If you prefer a qualified plan to an SEP IRA but you missed the deadline to establish a qualified plan, you may fund the SEP and then roll over the balance to the qualified plan that you establish later.
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