Last week, we showed how valuable a Solo 401(k) plan could be for a maturing small business. It is very easy to establish with low set up costs, high contribution limits, and are simple to administer. However, despite these advantages, Solo 401(k) plans possess one crucial flaw: they are available only to a business owner and his/her spouse with no common-law employees.
But what should you do if your business has employees, and establishing a traditional 401(k) is not an option due to its complexities and big expenses? Fortunately, there is no reason to get discouraged. Congress has provided small business owners with a few retirement savings plans, which are available at a lower cost and are easier to manage than traditional 401(k) plans. One such plan is the Simplified Employee Pension (SEP) IRA.
A SEP IRA is a non-qualified retirement plan, meaning it doesn’t meet requirements of the Internal Revenue Code. The SEP IRA can be established by all types of businesses, including government employers. In addition to that, the SEP IRA can be established by a business of any size, including self-employed. A SEP IRA plan is very easy to establish and doesn’t have any set-up costs. All you need to do is adopt Form 5305-SEP, or an individually designed plan document.
In order to participate in a SEP IRA, an eligible employee must satisfy the following criteria:
Be age 21 or older
Earns at least $600 during current year
Has worked for the employer in at least three of five immediately preceding calendar years
Nonresident aliens and union employees can be excluded from participation.
Eligibility requirements are the weakest spot of SEP IRAs. Why? Because, even part-time or seasonal employees have to be included in the plan, which essentially increases the cost for the employer. Nevertheless, employers can apply less restrictive requirements, if they want to.
All contributions towards a SEP IRA are made solely by an employer and are discretionary, meaning that the employer can stop making any contributions for a given year. However, should the employer decide to make contributions, he/she can do so up until the due date of their tax return, including extensions.
An employee must open a SEP IRA account with an independent custodian or trustee to which the employer will be making contributions. Since the account is owned by an employee, all contributions are immediately vested.
In terms of contribution limits, an employer can contribute either 25% of an employee’s compensation (or 20% of net earnings if self-employed), or $54,000 in 2017, whichever is less. For example, if you have an annual compensation of $150,000, the maximum you can contribute to a SEP IRA is $37,500 (25% of your total annual compensation). Many small business owners falsely believe it’s, “up to $54,000” and often contribute more than 25% of their annual compensation. Be careful, and avoid this common mistake so that you don’t have to correct it later. Also, be aware that catch-up contributions are not allowed.
All contributions are tax deductible for the employer and are not included in the employee’s gross income. For example, let’s assume that you contributed $150,000 towards your employees’ SEP IRA accounts, and your business has a taxable income of $1,000,000. This income essentially puts your company in a 34% income tax bracket. However, since your contributions are tax-deductible on business income, you will pay tax on $850,000 while saving you $51,000 in taxes.
When making contributions, it is essential that you make contributions to all eligible employees. Do not discriminate in favor of highly compensated employees. Two easy ways to satisfy these requirements are by making either pro-rata or flat dollar contributions. With pro-rata approach, contributions to all eligible employees are defined as a certain percentage of an annual compensation. For example, contribute to each employee 7% of his or her compensation (limited to the annual compensation limit of $270,000 in 2017).
In a flat dollar approach, you contribute the same dollar amount to each eligible employee. In practice, this approach is rarely used, as it results in a larger percentage of income being contributed to employees with lower income.
Even though employers are not required to file any Forms with the IRS, they still must do some reporting. Specifically, employers are required to furnish participants with a W-2, and disclose the amount of annual employer contributions made to each employee’s account.
In addition to that, the employer is required to give notice of the SEP IRA and a copy of Form 5305-SEP to each eligible employee.
Other Features of a SEP IRA
Participants in a SEP IRA are treated as active participants. This means in order to take a deduction for contributing to a Traditional IRA, they have to stay within certain income limits established by the IRS
Social Security integration or permitted disparity is allowed
Employer is not responsible for investment decisions and results made by participants
Loans are not permitted
Traditional 401(k) plans are expensive to set up, complex to operate, and require compliance with multiple laws, and regulations which make them a “no-go” for many emerging small businesses. SEP IRAs on the other hand, with their low set up fees, simplicity, no administrative hassle, and sugar-coated with high contribution limits, are a much better alternative. Employers enjoy discretion over contributions and can stop them at any time. In addition, SEP IRA employers are not responsible for investment results made by participants. This alone, considering recent litigation in the 401(k) arena, is a big relief for many small business owners.
However, we can’t say that a SEP IRA is flawless. The biggest disadvantage of a SEP IRA (that we see) is weak eligibility requirements. Current eligibility rules don’t favor the employer, because part-time and seasonal workers should be included in the plan. That alone, reflects an unnecessary rising expense for the employer. But, if you are comparing the advantages to the disadvantages of a SEP IRA, it will become clear that the pros greatly outweigh the cons.